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Private Investment Forum - Winter 2013


High Frequency Trading – Issues Facing Investment Firms



High frequency trading (“HFT”), also known as algorithmic trading, is a term that describes the practice of using powerful computers to execute large numbers of trades extremely quickly - thousands or even millions of trades per second. HFT is utilized for transactions in financial instruments that can be traded electronically, e.g., equities, ETFs, futures, options, and currencies.HFT systems have developed over the past decade or longer, but it is only during the past five years or so that they have come to truly dominate trading in the markets. HFT has become extremely prolific with respect to volume - many sources attribute 70% or more of trades by volume to HFT.

Typical characteristics of HFT strategies (“HFTs”) include:

  • They utilize computerized algorithms to analyze market data, and the resulting quantitative analysis uses highly sophisticated computers to implement the trading strategies.
  • They aim to capture and exploit just a fraction of a penny per share or unit on each trade, thus traders using HFT move in and out of short-term positions many times in a given day.
  • Investment positions are held for very short periods -- there is usually no net investment position held at the end of a trading day.
  • Proprietary trading firms and proprietary trading desks in large diversified firms are very active users of HFT.
  • HFTs often provide liquidity and price discovery to the markets through market-making and arbitrage trading; however, HFTs also take liquidity from the markets to manage risk or lock in profits.
  • HFTs are not used with fundamental analysis or “investing” - just trading. The very small profits for each trade – fractions of a penny - can accumulate fast to produce significant positive results at the end of the trading day.
  • Many orders are submitted, but a large portion of them are canceled very shortly thereafter.
  • HFT firms typically do not employ significant leverage, do not accumulate positions, and generally liquidate their entire portfolios by the end of each trading day.

HFT has many potential advantages, yet it also brings many risks and challenges to the markets and to firms that utilize it.HFT firms should be very aware of these risks and challenges, as well as the resulting scrutiny from regulators and changes in regulation that likely lie ahead.

Benefits to the Markets of High Frequency Trading

Increased Liquidity
HFT strategies frequently post two-way, continuous quotes and enter into a large number of trades. By contributing to a high percentage of order flow in the markets, HFTs can increase the level of liquidity.However, it is also theorized that HFTs merely increase volume without increasing liquidity because the limited depth and millisecond duration of the quotes do not allow other investors the ability to actually transact.

Narrowing Spreads
Securities prices are being updated with greater frequency and increased accuracy as the use of algorithms and computers in trading has become more prevalent.A NYSE Euronext study shows that quoted spreads from 2007-2009, during which time HFT became more widely employed, were lower than those from 2002-2006 – this suggests that traders are providing more competitive bid-ask prices with HFT and that spreads are narrowing accordingly.

Lower Trading Costs
Through increased liquidity and lower spreads, HFTs can lower transaction costs.HFT firms that participate in market making can smooth the pricing unevenness that can result from order imbalances. These cost reductions can benefit all market participants, from small retail investors to large institutional players.

Enhanced Market Efficiency and Pricing
When prices more quickly reflect market transactional information, the market itself should be more efficient. The very short time intervals involved in HFT enable more frequent, faster updating of price data and thus greater market efficiency.

Detriments to the Markets of High Frequency Trading

Increased Volatility
HFTs can give rise to price fluctuations and high short-term volatility due to the strategies’ high speed intraday trading in - and out of - positions generally held only for a few minutes or a few seconds.The price fluctuations HFTs cause can lead to overall volatility in the market since HFT volumes are normally a relatively high percentage of overall trading. Additionally, the practice of making trades and instantly cancelling them only to trigger automated buying from other firms may raise ethical issues, which have been noted by many analysts.1

Impact on Institutional Investors
Some institutional investors contend that certain HFT strategies look for repetitive trading patterns and “technologically front-run” the institution. The HFT system would detect an incoming order flow and buy the same security, then quickly turn around and sell it to the institution at a slightly higher price. These HFT strategies may adversely impact such institutional investors.

Market Unfairness and Disadvantages to Smaller Investors
HFT firms utilize special services such as co-location facilities and raw data feeds, which are typically not accessible by smaller firms and retail investors due to the large expenses required to obtain such services.This disadvantages these smaller firms and investors as they are unable to obtain the same level of information, or to act upon it, as the HFT firms.

Risks and the Regulatory Environment

Are the financial markets at risk of a large-scale meltdown if a computer-driven failure were to occur at a large firm or on a large scale?There have been several very well-known debacles in the recent past that have brought this concern to the forefront of both the public and the regulators, who are very interested in HFT and whether it is good or bad for the markets.These incidents include:

Knight Capital Group
On August 1, 2012, approximately 150 stocks experienced an abrupt surge in market volume during morning trading. The surge was attributed to Knight Capital Group, a market-maker and broker, who blamed it on flaws in the algorithms in its HFT platform.That same afternoon, officials decided to cancel all trades that were executed 30% above or below that day’s opening price 30% above or below that day’s opening price.Knight lost over $400 million almost instantly and had to seek a bailout to remain in business.

Facebook IPO
The hugely anticipated IPO of Facebook shares took place on the Nasdaq on May 18, 2012.

The initial trades of Facebook shares were delayed for about a half hour, however, because of a technological glitch.For the first two and a half hours of trading, virtually no traders were able to verify their Facebook trades.

Flash Crash
On May 6, 2010, several computerized trading systems halted executions due to market volatility that resulted from nervousness over European debt matters. The halted executions caused computers at other exchanges to interpret the freeze in trading as rapid bidding down of stocks. The Dow crashed, losing just shy of 1000 points and erasing close to $900 billion of market value.Then, just a few minutes later, the Dow regained nearly 600 points. The CFTC blamed trades of E-mini futures by Waddell & Reed Financial, the mutual-fund company, for triggering the chain of events.Although regulators have said the algorithms running HFTs were a factor, they have not blamed HFTs for actually causing the crash.

Regulatory Climate
The SEC and the CFTC are actively working to develop regulations to reduce the risks posed by, and to reign in, HFT.European and Canadian regulators also are actively assessing how to regulate and monitor the strategies.

The SEC has proposed a “consolidated audit trail" requiring exchanges to report every trade to a central repository, where they could later be analyzed. According to the SEC, it is a high priority project, but the agency does not know when the rules for it will be completed.

Regulators and market participants alike are aware that these issues have seriously eroded the public’s confidence in the markets, and that this needs to be addressed. “It will cost money to improve and modernize market structure,” says Bryan Harkins, chief operating officer at Direct Edge, the fourth-largest stock exchange. “But the short-term money pales in comparison to boosting investor confidence in the long term.” 2

Circuit breakers were implemented after the Flash Crash, and additional methods are being pursued to slow trading speed and volume if unusual trading patterns are identified.

Recommendations for Firms

Design and Testing
Firms utilizing HFTs must be extremely thorough with respect to designing and testing their algorithms over a very broad spectrum of conceivable market variables before putting the algorithms to work. In addition, firms should also shock their HFT systems for unusual and out-of-the-ordinary risks to build a system that is as robust as possible.

Utilize the Latest Technology
As competition continues to increase, technology is likely to move quickly. Frequent assessment of service providers’ offerings as well as the firm’s own infrastructure and its ability to utilize the best systems should be undertaken.

Compliance and Risk Management
Develop robust and adaptable risk and compliance monitoring processes carefully tailored to HFTs to handle the increasing regulatory and operational demands that lie ahead.

Todd K. Warren is Of Counsel in Sadis & Goldberg’s Regulatory and Defense and Compliance Group. Mr. Warren counsels investment professionals in connection with regulatory matters, including compliance and registration issues with the SEC and state regulators as well as preparation of written compliance policies and procedures, and he organizes and structures investment advisers and broker dealers. Sadis & Goldberg LLP is internationally recognized for its financial services practice that consists of representing several hundred investment advisers and related investment entities (including hedge funds, private equity funds and venture capital funds). Similarly, the Firm provides regulatory and compliance advice and representation in connection with SEC enforcement proceedings. Notwithstanding the emphasis on the financial services industry, the Firm also provides a full range of tax, litigation, real estate, intellectual property and corporate services to its clients.

1. High Frequency Trading: Evolution and the Future, Capgemini, 2012

2. Wall Street Journal – Intelligent Investor May 25, 2012




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