The Danger with High Frequency Trading

Monday, September 7th, 2009

Can’t see the video above? Click here to watch or read the transcript.

In this video interview, Davide Accomazzo, MBA, Adjunct Professor of Finance at the Graziadio School of Business and Management, discusses the dangers of high frequency trading. This interview is a follow-up to Professor Accomazzo’s essay for the GBR blog on the same topic.

Professor Accomazzo teaches global capital markets and investments/portfolio management and is a frequent writer on the topic of markets and other economic issues. He co-founded Cervino Capital Management in 2005 and is the company’s principal trader.

Questions for Professor Accomazzo:

  1. What is high frequency trading?
  2. Why is it a growing problem and who stands to lose?
  3. What is the worst possible scenario if HFT goes unchecked into the future?
  4. What kinds of checks and balances do you think should be put in place?
  5. Is there anything investors can do to mitigate the risks of HFT or is it out of our control?

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, Investing, Public Policy, Videos
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Comments

Michael

September 18, 2009 at 9:51 AM

Any idea that Chuck Schumer wants to regulate or ban by default must be a good idea. Politics aside, Flash trading is a new innovation that appears only to speed up the transaction process, not to game the system. Because any good idea on wall street that gives a trader an advantage or a perceived advantage in the market is quickly imitated and the advantage is lost. This is precisely what is happening WITHOUT REGULATION. About 9 years ago, I heard many of these same arguments against day traders during the internet boom. There were a few traders who made a lot of money, but most, like 95%, ended up losing money, some lost a lot of money. It was the brokerage houses that made the real killing. So it goes with flash trading. Let the market work itself out without government interference. If you are concerned about volatility of the market, we’ve seen enough volatility over the past year. It was not due to flash trading. (If you are really concerned about the market, you should tell the Fed to stop printing money. That will do more damage than flash trading ever will.) The only truism about investing still holds to this day, you are better off investing for the long term and diversifying your portfolio to lower your risk through index funds.

Recently, Donald Luskin wrote a piece in the Wall Street Journal defense of flash trading.

For the past several weeks, New York Sen. Chuck Schumer has attempted to intimidate the Securities and Exchange Commission into banning so-called flash trading. Eliminating this technique would be a dangerous mistake that would squash competition and automation in equity trading. Flash trading exemplifies the virtues of two decades of innovation that have improved executions for both individual and institutional investors.

What is flash trading? As pioneered by the electronic communications network Direct Edge, it is simply a way for one customer to query other customers to see if they will take the other side of a trade.

Let’s say that among all the exchanges, the highest bid for stock XYZ is 10, and the lowest offer is 10.5. Bob enters a flash order to buy 500 shares in between, at 10.25. This order exists in Direct Edge’s system for mere milliseconds, but in that time the high-speed computers of other participants might decide to sell Bob the 500 shares he wants to buy. So Bob gets a price better than the best offer, and the seller gets a price better than the best bid. If a trade can’t be executed, then Bob can try other markets.

In this example, because the flash trade comes in between the best bid and the best offer, it does not contribute to market volatility. Buyer and seller have entered into a trade in which they both feel they have achieved the best possible deal, or they wouldn’t have traded. And the flash order created an opportunity for new liquidity to enter the market.

Flash trading is like offering to sell your house to your neighbor before you officially put it into the real estate listings. For that matter, it’s just like what upstairs traders did in the pre-computer era: shopping an order before sending it to the exchange floor. We had no problem with this process, so why would we ban flash trading, which simply makes it more formal and produces an audit trail that the upstairs traders didn’t?

Yet according to Mr. Schumer, in flash trading “a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions.” The truth is that there’s no particular privilege involved. Any broker can enter flash orders or respond to them, even when executing on behalf of ordinary individual investors.

Chris Nagy, managing director of routing for TD Ameritrade, a leading retail broker, has said that his company sees flash trading “working so well that we’ve increased our utilization of it.” It’s hard to see how anyone is deprived of a fair price, since a flash trade cannot, by SEC rules, trade through pre-existing orders—that is, it cannot be executed below the best bid or above the best offer.

Mr. Schumer also claims that seeing flash orders allows traders to “act on that early information to trade ahead of the pending orders.” Yes, a flash order does reveal information. But so does any order. If flash orders entailed a heightened risk of being front run, as Mr. Schumer claims, no one would ever enter into them.

The real issue here is that innovators like Direct Edge are able to use new systems like flash trading to challenge entrenched institutions like the New York Stock Exchange by attracting their own new pools of liquidity. Innovators profit most when trading is internalized within their new pools, drawing market share away from incumbents. The incumbents typically seek self-protective regulation, characterizing the creation of new pools as “fragmentation” of the equity markets.

In fact, trading innovations do not create fragmentation. They expand the market, drawing in entirely new liquidity that wouldn’t have otherwise existed.

Since introducing flash trading in 2006, Direct Edge’s market share has soared to 12% from 2%. No wonder, then, that Duncan Niederauer, chief executive officer of NYSE Euronext, said in June that “we’re spending a lot of time in Washington.” And no wonder that Mr. Schumer has suddenly developed an interest in the microstructure of equity markets.

Competition is what makes America’s equity trading system the envy of the world. Let’s not throttle it by demonizing the innovations that improve it.


Davide Accomazzo

September 21, 2009 at 8:57 AM

I am in complete agreement with you that competition and innovation are the driving force of our system; however, you are incorrect in stating that flash trading is not a privilege for a few players. In terms of your remarks to volatility, clearly I never stated that all volatility comes from flash trading or HFT, however, an enormous amount of questionable volume is being generated by HFT which does create the risk for a liquidity vacuum. It seems that 40% of NYSE volume these days is in only 4 names, BAC, C and Freddy and Fanny..uhmmmm….


BHarat@ learn forex trading

January 25, 2010 at 8:41 PM

i think these type of people should be ban from trading.As it is creating an problems for people who are innovative in their creation.


james

April 2, 2010 at 4:07 PM

I would be surprised if flash trading is banned. Automated trading platforms that can handle HFT are highly propriety and I am sure they taken advantage of the visible in flow of volume internally as part of the overall algorithm.


Michael

October 20, 2010 at 12:19 AM

Davide, I am wondering is this 40% volume in NYSE with these issues have anything to do with the finacial backing and stimulas of capital put into these companies or at least some back by the feds and some fiscal policies? can this be some of the very people that traded these in the credit swaps? can this be some of the few players? it is an interesting senerio at least.


Shree Wasan

February 3, 2011 at 7:07 AM

My understanding is that this is very different from “trading on the noise.” In flash trading, what powerful computers do is see a trade coming in 30 milliseconds and make trades in 5 or 10 milliseconds to capitalize on the movement the stock price will make when the 30 millisecond ahead trade is executed. If I have this right the very fast computer sees, say, that someone is buying a large block of shares in 30 milliseconds and predicts that this will cause the price of that stock to rise so the computer buys some shares before the other purchase can go through and probably sells the stock again a second later.
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Afton Bock

February 10, 2011 at 8:16 AM

Hi, can I make a trackback from my blog to this?


John

July 24, 2011 at 12:58 AM

If it brings down trading costs for everyone, it must be a good thing.


Renay Cole

September 26, 2011 at 11:21 PM

I liked the article.I am an alumni here.I hope to have time to read more of your articles in the future as i really enjoyed it. It brings me back to the college days reading here. Thanks for taking the time and effort to write it.


Fern Garcia

November 16, 2011 at 2:46 AM

Great Post, thanks for all the good information. Keep it coming!