The tremendous evolution of the markets since the days of actual ticker tape and smoke-filled back-room deals is widely recognized, but perhaps even more noteworthy for everyday investors have been the changes witnessed during the last 15 years thanks to the proliferation of electronic markets.
While professional traders may mourn the days of the competitive, yet clubby, tightly packed pits on the floor, today’s electronic markets have ushered in a new era of competition amongst traders that is benefitting end users like never before.
Elements of electronic trading like colocation, proximity hosting and network connections allow for more market participants to have access to market data and post their orders than the limited space of the trading floor ever did. And for those who have long relied on the futures markets to hedge their risk, the benefits of electronic trading are equally significant, including lower costs, tighter spreads and greater liquidity.
There have always been professional intermediaries in the market—those willing to make markets at all times, providing liquidity to those who need the futures markets to lower the risks of their business. But as markets went electronic, professional traders on the floor found themselves facing a new breed of technologically savvy market participants who provided the same service to the market at lower cost, with narrower spreads and at greater scale. This shift in competitive landscape is no different from what we see across industries over time: those who invest in technology and evolve with the market thrive; those who do not are disrupted, losing market share and profitability.
The new market makers
These new, electronic, professional traders have the advantage of being able to manage their positions, prices and risk with greater accuracy and speed than their counterparts. They are incredibly efficient and can leverage their technological platforms to quickly scale, allowing them to interact with the market and provide fair prices at a much higher frequency than individual traders—whether in a pit, over the phone, or using a mouse—were ever able to do. Hence the birth of the term “high frequency trading” and the start of its application to define electronic professional trading models.
But what does high frequency trading [HFT] really mean? While the public discourse on the topic might lead one to believe it is a confusing and complex practice, it is fairly straightforward, complicated only by the false definitions applied to it by many market professionals themselves.
If you were to walk into a room of 20 different market professionals and ask them what high frequency trading is, you could get 20 different answers. If you ask them all again a week later, you might get four or five new answers in the mix. All too often the term HFT is falsely ascribed to a specific behavior in the market, good or bad. More often than not, a person picks the one behavior they do not like--or costs them money--and says that’s HFT!
At its core, HFT is nothing more than the modern, automated incarnation of professional trading. Professional traders have always played an integral role in financial markets, providing liquidity and contributing to the discovery of fair prices. As the markets have become electronic, professional trading has become increasingly automated.
Modern professional traders are unique among market participants in that they are willing to continuously buy and sell throughout the day, placing many of these firms in the top 25% of market volume. They use technology to process market data, price products, manage risk, and submit orders. Their custom-built technology platforms allow them to scale efficiently so they are trading in hundreds, if not thousands, of products simultaneously across many asset classes. For the most part, they base their trading on predictive models for short-term market movements and are fanatical about controlling their risk, so the smallest change in the markets can result in re-calculating their prices and changing their orders.
The speed, breadth of trading, scope of pricing strategies, and management of modern professional traders all contribute to interacting with the market at a much higher rate than has been seen in previous market eras. So to refer to high frequency trading as a specific strategy is a misnomer. Rather it is a style of trading often used to the benefit of many different strategies. In fact, high frequency trading is now used as a complementary tool too, so many strategies that to try to list them all would be a fool’s errand. However, looking at the role high frequency trading plays in the execution of certain strategies can help to further clarify the term.
Who are these guys
Some uninformed observers attribute manipulative or predatory trading to HFT, even in the absence of any demonstrative quantitative data. In fact, electronic markets give regulators more auditable data than markets have ever had in the past, and with the appropriate application of surveillance and analytic tools regulators can make great strides to rid the markets of manipulative behavior.
Market participants of all stripes, including those who use high frequency trading, would applaud such efforts.
High frequency traders are responsible for some predatory behavior because they are in the market and like all groups of traders, they are suscepible to bad behavior. But it is more likely caused by market structure issues than the fact that they use algortihms that are defined as HFT. Of course, a poorly constructed algorithm could also have a negative impact on the market, having nothing to do with whether the entity using it is attempting to manipulate the market.
Much of high frequency trading is passive market making, where the strategy rests on either side of the market, often on both sides simultaneously. The strategies are competing with each other to provide liquidity to those who need it.
This competition leads them to continually better each other’s prices, providing better and better prices to the market. Therefore when an investor or natural hedger needs to cross the market to get the size they need, they are doing so at a narrower spread, resulting in lower costs.
But this is not all that HFT does. There are numerous strategies that can come under the broad high frequency trading umbrella. It would be wrong to define these as good or bad, but you can certainly see that their effect on the market is different (see “Measuring HFT,” below).
High frequency trading is not only used for passive market making, but also a good deal of arbitrage strategies. These include the cross asset and cross market arbitrage strategies that have existed for as long as there have been markets. Furthermore, these strategies include statistical arbitrage, a set of strategies where mathematical modeling techniques are used to find pricing inefficiencies between groupings of products.
Some arbitrage strategies enter the market by resting. Others enter by crossing the spread, which can also benefit the markets. Just as high frequency traders are not always passive, investors and hedgers are not always aggressive. Many times investors and hedgers rest their orders in the book. If a professional trader’s strategy assumes the spread risk and fills an investor, then all the better for that investor.
While professional traders using high frequency trading provide a great service to the market, they certainly do not do so out of the goodness of their hearts. Rather, like all market participants, they provide services with the intention of making a profit. That profit is not guaranteed, and it should be noted that their trading is not riskless. For every successful use of high frequency trading, there are many more that do not survive. Those that do survive—and the very few that thrive—do so through constant innovation and an eye towards market and operational risk management.
Participants across the market have taken notice and are increasingly adopting the tools and techniques of high frequency trading. Banks, brokers, institutional investors, CPAs, and others have started to integrate the innovations of high frequency trading into their own platforms. As a result, they are becoming more efficient, allowing them to provide better services at lower costs, just one more way that the end users of futures products are benefitting from the advances of high frequency trading.
While the benefits of an electronic marketplace to all market participants are clear, the value to regulators should not be understated. A very real benefit of an electronic marketplace is that all activity is fully auditable and now, more than ever before, manipulation can be detected and removed from the market. When that goal is achieved, the vast amount of high frequency traders, like other responsible, legal and ethical participants in the markets, will contribute some of the loudest applause.
All good market participants want a healthy and sustainable marketplace and high frequency traders are no different. Today’s markets, including the futures markets, are efficient, fair, and resilient. The proliferation of electronic trading has improved market conditions over the last 15 years and we can expect to see that trend continue. High frequency trading, when properly understood and used responsibly, has been an integral part of that improvement over time.
Peter Nabicht is senior advisor to the Modern Markets Initiatve, an advocacy effort organized by some of the industry’s leading quantitative trading firms. Previously, he was Chief Technology Officer at Allston Trading, a Chicago-based proprietary HFT firm.