When it comes to your investments, what can you do with a few milliseconds?
If you’re a normal person handling your retirement portfolio, the answer is easy: nothing. If you’ve got a Wall Street computer equipped with powerful algorithms designed for high-frequency trading, you could earn—or lose—millions.
High-frequency trading, or H.F.T., first hit the stock markets in the 1980s. Computer algorithms make it possible to spot market trends almost as quickly as they appear, and then rapidly trade shares made available by slower investors. Thanks to these increasingly powerful algorithms, high-frequency trading will likely earn around $1.25 billion in profits this year.
But as we all know, computers can be glitch-y. In August of this year, Knight Capital, a trading firm that had built its reputation on its H.F.T. prowess, accidentally lost $440 million in stocks over a single morning, thanks to a malfunction in newly installed software. Earlier this week, two bids were made by other H.F.T. firms Getco and Virtu to take over Knight, which has been struggling since the summer scandal.
Due to events like this, regulators are starting to turn a critical eye toward high-frequency traders. Is high-frequency trading merely a lucrative trend that will soon fade away due to stabilizing markets? Are these super-computers putting normal investors at a disadvantage—or actually helping them?
We’ll take a closer look at what you need to know about high-frequency trading, and what kind of regulations—if any—should be put into place to protect your portfolio.
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How Exactly Does High-Frequency Trading Work?
Tech-savvy Wall Street firms have developed algorithms so powerful that they can scan dozens of public and private markets simultaneously in order to identify trends and place millions of orders per second. And since these computers process information much more rapidly than a human investor, they can change orders and trading strategies within milliseconds.
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A normal investor might research a company, become confident in its long-term prospects, purchase shares and then hope to sell them at a profit some years down the road. In contrast, the algorithms used in high-frequency trading firms can spot tiny price differences, and act quickly to benefit from them. For instance, the algorithms might notice that a stock is being sold on one exchange for one cent less than on another exchange. High-frequency trading algorithms could buy and sell millions of these shares almost instantaneously, turning a huge profit before a human might even notice the price difference.
High-frequency trading is most potent in a declining or volatile marketplace because these traders seize on the stocks offered for sale by slower investors. The years 2008 and 2009 were booming for high-frequency traders, but climbing indexes in the last couple of years have hurt firms that rely on high-speed trading. Additionally, the cost of producing new algorithms to increase trading speed by fractions of a second has hurt firms’ bottom lines.
How High-Frequency Trading Can Hurt the Average Investor
The race for greater and greater speed has caused concern for the fate of the normal investor, as well as the integrity of the stock market as a whole.
Integrity isn’t a trait that usually comes to mind when thinking of the stock market. But critics of high-frequency trading cite the true purpose of the market when pointing out the dangers of high-speed trading. The market, they say, exists so that companies and investors can discover how much an ownership stake (or a share) in a company is worth. When that stock goes up, it tells other investors to put their money in that company and similar ones.
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High-frequency trading, however, isn’t designed with this original intent in mind. Rather than trying to determine whether a share of Apple is worth more or less since the release of the iPhone 5, high-frequency trading operates through the manipulation of tiny price discrepancies. And since computers process at such a rapid pace and can execute millions of trades in seconds, the stock price of well-established corporations could fluctuate wildly--without rhyme or reason in the eyes of a human trader.
Critics of H.F.T. also worry that high-frequency trading forces ordinary investors to pay higher prices for stocks because:
- The computers pick up information about orders and push prices before they can be filled.
- Other investors can be confused by market fluctuations caused by high-frequency traders, which can issue and cancel orders almost simultaneously.
- There are worries that the crashes initiated by high-frequency trading--including the Knight Capital incident and the flash crash of 2010, in which the Dow lost almost 1,000 points in 20 minutes before bouncing back--destabilize the market. The 2010 crash caused several companies to lose nearly $1 trillion of market value due to a crash initiated by a single high-frequency trading firm. Greater volatility of this kind could mean less stable long-term investments for investors.
The head of U.S. Equity Trading at T. Rowe Price, Andrew M. Brooks, told The New York Times, “You want to encourage innovation … but we’re moving toward a two-tiered marketplace of the high frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity.”
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How High-Frequency Trading Can Also Help the Average Investor
High-frequency trading isn’t all bad. Calls for more regulation led the British government to launch a two-year study on high-frequency trading. The findings? H.F.T. may actually be a good thing for ordinary investors--isolated crashes aside.
The study primarily rejected the claims that high-frequency trading has caused greater volatility in the market and manipulated stock prices. And in direct contrast to the critics, the study showed that competition between high-frequency trading firms has actually made it easier and cheaper for normal investors to buy or sell stocks.
Lastly, three empirical studies conducted by the British government found no evidence of the market abuse or price manipulation claimed by critics of high-frequency trading.
Should High-Frequency Trading Be Better Regulated?
The British government’s recent study and high-frequency trading’s most outspoken critics appear to be diametrically opposed in their claims. Given that more research seems necessary, is it appropriate for the SEC to impose harsher regulations on high-frequency trading firms?
The following countries are already working to restrict high-frequency trading:
- Germany Chancellor Angela Merkel approved draft legislation--still pending approval--that would require all high-frequency traders to be registered, necessitate more transparency regarding the financial products traded by algorithms and limit the number of orders placed without a corresponding trade.
- European Union The EU is discussing similar but stricter restrictions that would apply to all of its 27 member nations, including Germany. Recommendations have included mandating a slower speed of trading, and making it more costly for firms to cancel large orders of stock. These restrictions would aim to protect the everyday investor by lessening market volatility. Other restrictions being discussed would aim to prohibit price manipulation.
- Australia The Aussies have pushed further ahead than European countries with legislation pertaining to high-frequency trading. Over the next six to 18 months, controls will be implemented to restrain dramatic price swings, and new data reporting requirements will be mandated.
What About the United States?
Attempts to restrict H.F.T. have so far gained little traction. In 2010, then-Delaware Senator Ted Kaufman and Ohio Senator Sherrod Brown proposed the Brown-Kaufman amendment, which would have limited the size of big banks and addressed the risks of H.F.T.
In the middle of their push for legislation to restrict H.F.T., the 2010 flash crash mentioned above occurred. That afternoon, the Senate held a vote on the bill, which was defeated 61-33. As The New Yorker put it, "In the span of a few hours, they had been vindicated by the flash crash, then thoroughly whipped by the 'too big to fail' argument."
Recently, the Securities and Exchange Commission, which governs the stock market in the United States, admitted that it did not possess the technology to oversee the speed of trading and practices made possible by technological advances in high-frequency trading. (Find out about the recent change in leadership at the SEC.) A new program, which the S.E.C. will put in place by the end of the year, will help the regulating body play catch-up with high-frequency trading firms and better understand what controls—if any—need to be put in place.
Given the relative newness of these powerful algorithms, it may be many years before we understand how H.F.T. truly affects the marketplace, and whether stricter regulations are needed to protect the portfolio of the everyday investor.
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