The Two Faces of a High Frequency Trade

Some of the main features of the HFT are:

• A high volume of trades with a low level of profit per trade.
• The operation is maintained for an extremely short period of time, even reaching the order of microseconds.
• No significant positions are held at the close of the market.

For decades, technological advancement has had a profound impact on the way in which financial assets are traded. These technological advances have led many investment firms to carry out hundreds of operations in different markets faster than the human eye is capable of perceiving. 

This evolution in the markets is often referred to under the umbrella of High Frequency Trading (HFT) and has become a subject of heated discussion in recent years. Many have a negative perception of this practice in the industry, however, some believe that it is undeserved; that the HFT is neither more nor less than a natural evolution of a system that has been in operation for decades.

Who Uses High Frequency Trading?

HFT is often used by market makers. In strict price-time-to-market priority, market makers are successful, as they obtain benefits depending on whether or not they are the first to position themselves at the best available prices. Hence, speed is very important from a risk point of view, because it allows them to quickly update their quotes when market circumstances change. HFT is also used by firms that employ statistical arbitrage strategies.

 In market liquidity creation activities, the profit per trade is normally very small, and these strategies are normally implemented automatically using HFT.

Some traders believe that these types of strategies are legitimate and perfectly valid, as they add real value to the quality of the markets. However, when HFT is used to violate the time-price priority and firms are able to position themselves at the head of the queue or, when brokers use HFT technology to benefit from expected price changes resulting from orders from large clients, these strategies are not really beneficial and could in fact be detrimental to the quality of the market.

Recent scientific advances have shown that when HFT is used for market making activities or in the use of arbitrage statistics, HFT generally increases the liquidity of markets and reduces their volatility. In addition, dispersion is reduced, it guides the ticks with the lowest price and this improves the quality of the market. These HFT effects benefit all market participants, from small investors to large brokers and institutional investors.

Although as we have discussed, scientific advances show that HFT is generally beneficial to the market, there are many myths circulating around this. HFT has been, for example, accused of withdrawing liquidity when markets are volatile, although the facts show that this is not the case. HFT firms are sometimes accused of a myriad of market problems, when they are not really the culprit.

Based on such misconceptions, some policy and regulatory bodies have recently proposed introducing additional regulations to limit the effect of the HFT. All of these proposals introduce a financial transaction tax that will have a greater and more dramatic impact on the quality of the market. Trading volumes will be significantly reduced and liquidity and prices will be the ones where the impact will be greatest, and this hurts not only HFT but all market participants. Other measures, such as imposing price obligations or minimum operating times, reducing the speed with which HFT firms operate, will result in a greater dispersion or reduction of liquidity.

Fields of Application

Among the activities where the HFT takes place we can highlight three: market creation, statistical arbitrage and other investment strategies.

Market Creation

The main function of a market maker is to maintain a continuous price and provide the market with two aspects, supply and demand; to ensure liquidity and accurate execution to investors. Technological evolution in line with price sophistication has led the development towards more and more automated trading practices. Employing high-speed and automated trading applications allow market makers to trade higher volumes, with higher speed and smaller spreads, thereby ensuring liquidity and increasing the ability for market participants to transfer their risks. HFT also facilitates the process of market data, the reaction time to changes in market conditions and, therefore, market makers make a profit by generating tiny profits on a large number of trades.

In a market of strict time-price priority, the success of market makers depends on positioning themselves first to obtain the best prices available. When market makers provide a quote, they are exposed to the risk that the market will turn against them. When latency is low, however, a market maker can quickly and continually update their quotes to reflect the new market situation, ultimately allowing them to trade with a narrow spread. It follows from all this that the use of fast and sophisticated applications is a prerequisite for market makers if they are to be successful.

Statistical Arbitration

Statistical arbitrage involves a trading strategy that attempts to capitalise on an inefficient price of financial instruments, often characterised by temporary aberrations in the relationship between two financial instruments. An example that one might think of is the trading price of some stock or the trading price of the DAX index relative to the EuroStoxx. This normally entails taking long positions on the devalued instrument and short positions on the overvalued instrument. More advanced statistical arbitrations can consider not only a couple of data, but in fact tens or hundreds of them, in which some are bought and others are sold. As in market making activities, the profit per trade is normally very small, so these strategies are usually implemented automatically using HFT as well. To arbitrate such minute price differences, these firms contribute to market efficiency.

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Other Investment Strategies

Market making and statistical arbitrage strategies are legal trading strategies for many that add real value to the quality of the markets. Of course, there may be other strategies using HFT that do not fall into these categories. There are many who agree that these other strategies using HFT are not necessarily beneficial, and may in fact damage the quality of the market. We are going to give an example of these statements. Imagine a situation where a broker is buying index futures contracts, while at the same time an important, fairly large client executes an order of the same type. Obviously thanks to the speed of positioning of the broker, they will benefit from their client's order.

The Impact of HFT Strategies on the Markets

Most of the firms that use HFT, as well as other bodies, think that when HFT is used for market making activities, and in statistical arbitrage activities, the HFT does not harm the market. On the contrary, they claim that these practices often contribute to the quality of financial markets. Some of these benefits are those that are tried to detail next:

Increased liquidity by providing continuous quotes, as market makers give liquidity to them. In this way investors are always able to buy or sell a financial instrument.

Using computer programmes and trading algorithms, HFT firms can now trade a greater diversity of markets and financial instruments at the same time, thereby adding more volume. All investors benefit from this, as they can trade larger sizes as well.

In the last five years, the daily volume on the New York Stock Exchange (NYSE) has grown from 2 trillion to 5 trillion shares mainly due to high frequency traders. This spectacular volume means that large blocks of stocks can be moved more easily without taking too much price risk by moving against them. So, we have moved from a market in which humans operated manually, to one in which computers perform most operations without human intervention. The total volume is higher, but the size per trade has become smaller, so it is now easier for institutions to divide orders into smaller components, thus reducing the impact of the market.

Reducing Dispersion

The use of fast computers and software has led trading firms to quote more confidently and update prices more frequently. For market makers, this means that they can trade with reduced dispersion, so the risk of out-of-time quotes or incorrect prices of a financial instrument is significantly reduced. The consequent reduction in latency of the different exchanges, better known as exchanges, has continued its trend. In this way, the HFT establishes the true balance of supply and demand in the financial markets.

Reduction of the Volume in Ticks

The increasing activity of the HFT has led to a decrease in dispersion, as mentioned in the previous paragraph. This development, together with an increase in the message capacity of the different trading floors, has led to a significant reduction in the volume of ticks. These lower volumes in ticks have led to an increase in the market's capacity to facilitate small dispersions. If the volume of the ticks had not changed, the benefits in terms of dispersion and liquidity would have been less significant. In other words, the decrease in tick volume has removed an important barrier to price competitiveness and earnings.

Decrease in Cost per Transaction

By adding liquidity and reducing the dispersion between bid and ask prices, firms operating in HFT contribute to a decrease in the cost of operations. Their willingness to buy when others decide to sell and vice versa, reduces the price effects of the imbalance of orders and also reduces the cost per transaction for the final investor. Due to the HFT, the average transaction cost per operation has fallen substantially in the last decade. For example, a retail investor could pay around 1% on average for a transaction ten years ago, while that same investor can now enter the transaction for 25 basis points, or even less. For institutional investors, the reduction in transaction costs has also been considerably good.

Reducing Volatility

Market makers reduce volatility by resetting markets to operate as they are required to trade. They create orders and increase liquidity, making the markets a good place to do business. But market makers are not the only ones reducing volatility. Some of the studies carried out on the impact of HFT on market quality show that, in general, with HFT volatility is lost.

Improved Market Quality

By increasing liquidity by electronic market makers, reducing dispersion, transaction cost and reducing volatility, HFT contributes to overall market quality. So both the private and institutional investor benefit from the presence of the HFT in the markets.