High Frequency Trading: staying in control at the speed of light

August 12, 2014 Categories: Investment Strategy

russell-investments-wire-blog-speed-of-light-banner

The investment industry has been getting a bit of a battering lately.

Firstly, the film ‘Wolf of Wall Street’ showcased the luxurious lifestyle of real-life stockbroker Jordan Belfort who defrauded thousands of investors through a securities scam, in order to fund an excessive lifestyle of drugs, fast cars and lavish parties, which eventually (and quite rightfully!) landed him in prison.

More recently, Michael Lewis’ latest book ‘Flash Boys’ vividly conjures up the idea of the latest Ferrari-driving, champagne swilling spivs who are paying for it all by fleecing you and me. His protagonists are a band of noble heroes battling to wrestle control of the markets back from this latest breed of financial villain: the high frequency trader (HFT).

So this got me thinking: how real is this picture? Are these HFTs as corrupt and bad as the Wolf of Wall Street, or is there a common misconception about the practice which is making investors unnecessarily fearful?

What is HFT?

High Frequency Trading (HFT) is a big part of our market landscape today. It comprises roughly 50% of the market volume in US markets1 and 22% of volumes across the EU.2 It is born of the rise of high speed electronic trading, along with fragmentation of the market across a variety of exchanges and trading venues such as ‘dark pools’3.

HFTs trade using sophisticated computer algorithms to capture and process data from the various trading venues, and to create and implement the resulting trade orders. The speed at which they can do this is limited, quite literally, by the speed of light – the speed at which the data can travel along fibre-optic cables – and the physical distance the data has to travel. To reduce the latter, HFTs compete with each other to have their data processing technology physically located close to exchanges’ technology. Exchanges charge for so-called ‘co-location’, and this has become a become a big area of growth for them.

HFT can be good, or it can be bad

HFT is not a single thing. It is a collection of strategies. Some of these strategies are beneficial to markets. Others are less constructive at best, predatory at worst. In its benign form, HFT is passive market making and arbitrage. The benefits of these strategies are reduced spreads and reduced intraday price volatility. In a recent speech, the chair of the U.S . Securities and Exchange Commission (SEC) quantified some of these benefits, noting for example that: “for institutional investors, the costs of executing large orders, measured in terms of price, were more than 10% lower in 2013 than in 2006”. These are good things. In its more predatory forms, HFT strategies are directional or structural in nature, creating misleading momentum trends and exploiting structural inefficiencies (mainly around speed to market) to disadvantage market participants.

Understanding the business models and incentives

In my view, none of the enabling conditions for HFT are inherently bad (in fact, much is good) but some perverse incentives are embedded in the market structure that can lead to the more disruptive forms of HFT4 . One of the best ways to curtail the less constructive aspects of HFT would be to remove those perverse incentives, rather than blunter prohibitions or other specific rules-based approaches. The key to achieving this is first understanding the business models and incentives for all the market participants, including the trading venues. Once the incentives are understood, any proposed policy changes should consider potential unintended consequences of rulemaking. For example, regulatory changes meant to limit the less constructive HFT elements, such as the anti-disruptive rule proposed by the SEC , might negatively impact the beneficial HFT strategies such as passive market making. Care must be exercised.

Clearer regulations will force greater accountability

I’m encouraged that regulators globally are taking this approach, working to grow the body knowledge about the firms and exchanges they regulate by conducting more thematic reviews. They’re setting out their approach and expectations clearly, and publishing their findings, so the industry can be held to account if they fall short. And they’re promoting general awareness by reminding institutional investors of their own fiduciary duties with respect to trading practices and best execution.

Retain control through alignment of interests

Regardless of what the future holds for HFT, trading continues every day. But that doesn’t mean that the markets are out of control nor does it mean that you need to lose control when you trade. Organisations can equip themselves to deal effectively in the markets where all forms of HFT exist. For example, by taking steps to:

  • Establish broad, wide-ranging connectivity to relevant liquidity sources
  • route trade orders intelligently by understanding which liquidity sources maximise the likelihood of achieving execution success
  • minimise information leakage, foot print, and market impact
  • ensure that the interests of the agents trading on your behalf are fully aligned with your own.

That last point is particularly pertinent for many institutional investors who rely entirely on agents to transact on their behalf. Financial services, at any level, work best when interests of principals and agents are fully aligned. Many, or perhaps even most, financial scandals have some misalignment of interests at their epicentre. So for many investors, ensuring that strong alignment of interest between them and their agents is the single most important, and sometimes the only, step that they must take to stay in control – even at the speed of light.

1 http://www.sec.gov/rules/concept/2010/34-61358.pdf (Page 45)
2 ESMA Report on Trends, Risks, and Vulnerabilities, No. 1, 2014
3 Dark pools are private trading venues used by institutions seeking anonymity and liquidity outside of traditional public exchanges.
4For a fuller discussion, see the section headed ‘Mitigating Broker Conflicts’ in the Chair of the SEC’s recent speech

Jason Lenzo, Director, Equity & Fixed Income Trading

Jason-Lenzo

  1. No comments yet.
  1. No trackbacks yet.

DISCLOSURES

For Professional Clients Only.

This material does not constitute an offer or invitation to anyone in any jurisdiction to invest in any Russell Investments Investment product or use any Russell Investments Investment services where such offer or invitation is not lawful, or in which the person making such offer or invitation is not qualified to do so, nor has it been prepared in connection with any such offer or invitation.

Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate. Any opinion expressed is that of Russell Investment, is not a statement of fact, is subject to change and does not constitute investment advice.

The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested.