By Bernard Kellerman

High-frequency trading has received a lot of negative press in recent times, particularly since the publication of Flash Boys: A Wall Street Revolt in 2014 by noted financial markets writer Michael Lewis.

High frequency trading now accounts for up to 70% of all equities trades in the US, but no more than half of that in other comparable markets. At its most basic definition, HFT is a system of computer programs “testing the market” by sending out millions of buy and sell orders and amendments per day – the majority of which do not go through to execution.

The programs can then predict the direction of trades, the likely price and buy the stock at a lower price. The shares are then on-sold at the higher price – all in a fraction of a blink of an eye.This is known as “front-running” and is perfectly legal.

Done in a flash

The “flash” of Michael Lewis’ book refers to another aspect of trading in which certain market participants are allowed to see incoming orders to buy or sell securities very slightly earlier than the general market participants, typically 30 milliseconds, in exchange for a fee. It was this exposé that particularly riled investors.

This feature was introduced in the US to allow participants, like market makers, the opportunity to meet or improve on the national best bid and offer price to ensure incoming orders were matched at the most advantageous prices according to the Regulation National Market System (or Reg NMS) aimed at consolidating US securities market rules.

A millisecond is an eon when your system is able to make a decision in ten microseconds.

As Mike Beller, chief operating officer at New Jersey HFT firm, Tradeworx, told US science podcast Radiolab, a millisecond is, “an eon when your system is able to make a decision in ten microseconds “.

All of which led Lewis to make this core assertion in Flash Boys – that high-frequency traders have “rigged” the stock market, profiting from speeds unavailable to others and getting a first look at trades from other large investors, brokers and hedge funds. So, the debate really is about speed – a race that is played out at speeds faster than humans can think, far less act.

Information arms race

The information arms race that defines financial markets trading has been underway for centuries. Andrew Zolli, a futurist with a special interest in the impact of technology on global society, has observed that market-moving information has always been of value, and the transfer of information has a speed that can be measured.

He gave as one example a step taken by Paul Julius Reuter, founder of the financial news service that still bears his name. In 1850, Reuter used carrier pigeons between Aachen and Brussels to bridge a gap between two telegraph systems, and so communicate stock prices between Paris and Berlin faster than the competing mail train, or even by a man on horseback (the pigeons were soon superseded by a direct telegraph Paris-Berlin link in 1851).

"Any suggestion that high-frequency trading is pervasive in Australia is simply not supported by the evidence."

As recently as 20 years ago, when open outcry was still in vogue, the average time to settle a trade was 11 or 12 seconds. Then, when all trading went electronic in the first decade of this century, markets fragmented and more hi-tech oriented competitors seized market share from monopoly incumbents. In the US, this translated to a market with 13 regulated exchanges and about 50 “dark pool” exchanges.

Research

The speed at which differences in markets are exploited, often for a few cents in each trade, causes pricing to converge across multiple markets. Academic research from many sources suggests that this aspect of HFT has brought down the average cost of trading. And related research in Canada and Australia tends to show up the HFT debate as much more of an American regulators’ conundrum.

Using data provided by the Investment Industry Regulatory Organization of Canada (IIROC), three North American financial markets researchers looked at the effects on two core measures of financial market quality: price discovery and liquidity. Price discovery is the process of buyers and sellers determining a market price at a particular time. Liquidity captures the cost of buying and selling securities and is an important factor in any investment strategy.

In their paper Market Integration and High Frequency Intermediation, Jonathan Brogaard (University of Washington), Terrence Hendershott (University of California, Berkeley) and Ryan Riordan (Queen’s University, Canada), drew on data from the seven Canadian exchanges.

“We find that HFTs are responsible for the bulk of price discovery but that they are less important for liquidity,” they reported in December 2014.

They found that HFTs were responsible for between 76% and 80% and non-HFTs were responsible for between 20% and 24% of price discovery. HFTs set the price.

The results are interesting because HFT trades were roughly 22% of the total volume measured by dollar volume. The authors suggest the quoting activities of HFT help to improve the efficiency of markets.

Closer to home

Australia’s primary financial markets regulator is the Australian Securities and Investments Commission (ASIC). ASIC is firmly convinced that nothing is out of line under its watch.

A spokesman reiterated the comments his agency made at the time that Flash Boys was released.

“The book’s author claims that high-frequency trading firms and their fast computers have effectively ‘rigged’ the US stock markets, and in doing so have made billions of dollars by leaping in front of investors.

“While many local media outlets have been quick to try and draw parallels with the Australian market, any suggestion that high-frequency trading is pervasive in Australia is simply not supported by the evidence.”

This is an abridged version of a feature that was first published in the March 2015 issue of Acuity magazine.