High Frequency Trading: The Rise of the Machines

Monday, August 10th, 2009

Davide Accomazzo
Davide Accomazzo, MBA

As a professional trader, you are confronted daily with all kinds of dynamics and situations that require a flexible and adaptive mind. You are faced with multiple variables constantly interacting with each other and your task is to process ever-changing information quickly and profitably. Valuations arbitrage, reflexive supply-and-demand dynamics, and structural changes are recurrent landmines in the typical day of traders and money managers.

We accept this “dangerous” line of work for only two reasons: monetary compensation and pride in being part of capital markets, that transmission mechanism without which innovation and creativity would be prisoners of their own ethereal state.

As a society, we are ready to strike compromises in return for a system that will allow the ethereal state of our creativity to turn into reality. We allow market insiders like market makers, broker-dealers, and others to have small advantages over us mortal investors in order to have them create the positive externalities that help us build a more sophisticated economic system. We give market makers and specialists a privileged look at the order flow (the supply and demand of stocks) in exchange for their commitment to maintaining orderly markets whenever an imbalance occurs. We give systemic firms like JP Morgan and Goldman Sachs privileged access to liquidity via the Federal Reserve so that the banking system and capital markets can continue to serve us in our quest to invent, produce, and distribute new products.

But sometimes things turn out more like a bad inland casino rather than a better market…

We may still be reeling from the systemic economic collapse of last year, but new structural changes with potential negative externalities are already at our door.

For months I have witnessed strange dynamics in the way markets behaved: liquidity issues, intra-day volatility, and a constant disconnection between technical, sentiment and fundamental inputs. Markets often go through periods of irrationality, but this time it felt different.

As a professional trader and an educator on markets, my sensitivity level is higher than normal and I immediately began conducting research to make sense of my discomfort. This process pointed consistently to one element: high frequency trading or as I like to call it “the rise of the machines.”

What is High Frequency Trading?

High frequency trading (HFT) was, until recently, a topic confined to Wall Street insiders. Only in the last few weeks has it become a mainstream subject of debate via articles on the New York Times, the Washington Post, and interviews on CNBC (yes even CNBC’s clueless anchors can now spell HFT).

The reason for this foray into the mainstream media is the potential negative ramifications HFT can have for all of us: investors, entrepreneurs, and just plain hopeful citizens.

But first, let’s define HFT as it is a very technical classification that, nonetheless, encompasses many different things. Generally speaking, HFT is high velocity trading based on mathematical algorithms that create huge daily volume on different electronic exchanges and platforms. It is machine against machine—endless trading in order to capture fractions of pennies in profits. But, so far so good: the machines provide liquidity to all of us. The owners of the machines (financial institutions) make an all-American profit and the liquidity aggregators (electronic exchanges) provide competition to other exchanges in the most capitalistic way.

But what happens if we scratch the surface? Like Michel de Montaigne, the famed Renaissance scholar, once said: “There is no man so good, who, were he to submit all his thoughts and actions to the law would not deserve hanging ten times over.”

High frequency algorithmic trading is ridden with issues:

  1. Volume. Machine-driven trading is over 60% of trading volume on a daily basis and in some confined cases it can be as high as 90%.
  2. Adaptability. Machines are unthinking units that do not adapt to human reactions. HFT algorithms are based on correlations and historical relationships, which are great guidelines for trading and investing but by no means they can be used blindly (see: 1987 portfolio insurance, long-term capital management 1998, credit default swaps 2008, mortgage-backed securities 2008…the list of quant-related disasters is a sad one).
  3. Exclusivity. HFT can only work by using incredibly fast and powerful computers that also must be placed in the exchanges as proximity helps the speed. Few people can afford the computers and/or the co-location fees charged by the electronic exchanges.
  4. Flash quotes. Some brokers have access to quotes of orders before anyone else. By exploiting the speed of their machines, they can either arbitrage price differentials or potentially front-run clients. Another abuse of flash quotes (called flash because they last one–to-three milliseconds) is that they can be used as teaser quotes to gauge supply and demand without the risk of being hit due to their quickness.
  5. Rebates. Many high frequency traders trade not for profit but for rebates paid by the electronic platforms to attract liquidity. This escamotage incentivizes useless and toxic volume.

While these are only the most immediate concerns about HFT, they have a potentially disproportionate influence on the cost of running our capital markets. The HFT lobby pushes the argument that they create positive externalities by exploiting improving technology—but there is a difference between volume and liquidity.

If over 60% of trading is toxic, it will go away in a nanosecond and most likely it will dissipate right when investors and money managers need it the most. This could cause a huge liquidity vacuum and a 1987-type of event. Liquidity is created by market players with a stake in the game, not by casino-like machines. Flash quotes and “predatory algorithms” also raise the cost of execution for the necessarily slower institutions like pension funds and mutual funds. Additionally, the surreal tempo of machine trading makes trading for all more expensive as we now have to prepare for the irrational moves and volatility of markets when executing our trades.

I love this business and I love technology, but checks and balances are needed to preserve our capital markets.

Little adjustments can be made to reduce systemic risk, like re-instating circuit breakers that cut off program trading when price changes accelerate beyond certain parameters, like investigation or stopping flash quotes that drive front running, like making good on teaser quotes for longer than just three milliseconds, and so on. In the end, we need to understand that capital markets are here not to destabilize our economy, but to serve us as a society and help us make better lives.

Sources
Paul Wilmott, “Hurrying Into the Next Panic?The New York Times, July 28, 2009.
Tobin Harshaw, “Is Wall Street Picking Our Pockets?” The New York Times, July 24, 2009.
Sal Arnuk and Joseph Saluzzi, “Toxic Equity Trading Order Flow on Wall Street,” white paper, Themis Trading LLC.

Related in the GBR

Is Managed Futures an Asset Class? by Davide Accomazzo, MBA, and Michael “Mack” Frankfurter

Examining the Role of Short-Term Correlation in Portfolio Diversification by Jeffry Haber, PhD, and Andrew Braunstein, PhD

The Buffett Approach to Valuing Stocks by Steven R. Ferraro, PhD, CFA

Topic: Finance, In the News, Investing, Public Policy
Tags: , , , , , , , ,

Comments

Stock Forum

August 23, 2009 at 4:48 PM

Wow awesome insight into a formulaic view of the markets – not sure I buy some of it, but very good read nonetheless.


Erik

August 27, 2009 at 5:12 PM

1. You haven’t painted a completely accurate picture. HFT makes trading more expensive? Not necessarily. HFT has resulted in increased competition for spreads… resulting in bid/asks spreads to be at very tight levels. I see technological advancement… not a systemic alert for the general public, and all “professional” traders.

2. You mentioned that flash trades are front running the public. Again, not necessarily. And, ANYONE can gain access to flash orders! They are there so a certain market centers can improve a bid before it is sent out to another market center. Reality is, the same information is available to you and I…. the only difference being, we cant react at the same speed as an algorithm. So, pick your spot and place a limit order.


mark harrison

September 4, 2009 at 10:41 AM

I’m sorry Davide but you are incorrect on one point. HFT has become so competitive that it has resulted in LESS expensive spreads, not more expensive and I think that most people would be in agreement with me on this.


Davide Accomazzo

September 21, 2009 at 9:07 AM

Thank you all for your feedback which is very much appreciated on such a complex and timely issue. In regards to spreads, in some cases they may be tighter but the overall cost seems to be certainly higher when you consider generally higher costs for slower, larger institutions (which manage the majority of funds), an increased intra-day volatility and the risk for liquidity vacuums. And you don’t want to get me started on rebates….


Mike Rowan

October 23, 2009 at 7:55 PM

Interesting point of view. While I agree with most of your article, I would also like to hear your opinion on how much computer trading contributes to the overall volatility of the markets.

In my opinion, they do quite a bit, but they take emotion out of the swings and probably capitalize on the average investor who falls prey to the market fluctuations.


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November 3, 2009 at 11:18 PM

“In my opinion, they do quite a bit, but they take emotion out of the swings and probably capitalize on the average investor who falls prey to the market fluctuations.”

I think computer trading helps the beginner trader. Not only can they get their feet wet but your exactly right it takes the emotion out of the trade. I think that is the biggest factor of succeed or fail, especially when you determine the size of the risk involved.


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January 13, 2010 at 4:16 PM

Because of this, it attracts people from all nationalities around the world, as well as, beginners and experts who are trying to make their fortune trading currency.Another exciting feature


Wisconsin Fireworks

March 17, 2010 at 10:50 AM

Who are the big players in high frequency?


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April 20, 2010 at 1:27 AM

The opposite most vital factor to think about is the compatibility with the present plant. This needs to be taken care of critically in any other case it should price you high. Considering these factors will assist you to arrive at a remaining choice which will not solely save your value but also present added functionality.


Paul penny shares trader

August 3, 2010 at 9:50 AM

I personally don’t approve of the mechanics of using machines in trading, and prefer the eyes on trading. Machines (computers) as you rightly put are inflexible, they don’t judge they just operate on instructions. Quite often trading needs fast adaptation to prevent significant losses, and machines can’t adapt themselves. As people we become to reliant on computers and machines, and this could lead to severe losses especially when trading.

Thanks I really enjoyed your post, and points of view.
Paul


Danielle

September 10, 2010 at 4:01 PM

“Those two hours now make up more than half of the entire day’s trading volume, according to an analysis of data provided by Thomson Reuters. In August, the first and last hour generated nearly 58% of New York Stock Exchange primary volume, up from 45% in August 2005, the analysis shows. The rise of high-frequency trading, where algorithms are used to exploit small discrepancies in high-volume situations, amplifies the concentration of trading at the beginning and end of the day, analysts say.”

From the WSJ today http://online.wsj.com/article/SB10001424052748704392104575475781704072278.html?mod=WSJ_hp_editorsPicks_2


sohbet odaları

September 28, 2010 at 1:05 AM

I’m sorry Davide but you are incorrect on one point. HFT has become so competitive that it has resulted in LESS expensive spreads, not more expensive and I think that most people would be in agreement with me on this.


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September 28, 2010 at 1:06 AM

“In my opinion, they do quite a bit, but they take emotion out of the swings and probably capitalize on the average investor who falls prey to the market fluctuations.”


Cheap Forex Systems

October 23, 2010 at 8:11 AM

I personally don’t approve of the mechanics of using machines in trading, and prefer the eyes on trading. Machines (computers) as you rightly put are inflexible, they don’t judge they just operate on instructions. Quite often trading needs fast adaptation to prevent significant losses, and machines can’t adapt themselves. As people we become to reliant on computers and machines, and this could lead to severe losses especially when trading.

Thanks I really enjoyed your post, and points of view.


R.MURPHY

March 9, 2011 at 12:48 PM

I like the topic The Rise of the Machines.


gipedan1

August 17, 2011 at 7:40 PM

Great site, I liked it!


maisto papildai

February 6, 2012 at 1:40 AM

No way I could justify auto trading. If you dont have control you going to cry at the end


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March 12, 2012 at 9:02 AM

The opposite most vital factor to think about is the compatibility with the present plant. This needs to be taken care of critically in any other case it should price you high. Considering these factors will assist you to arrive at a remaining choice which will not solely save your value but also present added functionality.


Amanda Gillam

August 20, 2012 at 1:42 AM

Although I do not agree with all of your comments, your article makes a fascinating read. As with Mark’s comment from October, ‘I would also like to hear your opinion on how much computer trading contributes to the overall volatility of the markets?’


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  1. The Danger with High Frequency Trading at Graziadio Business Report Blog