High Frequency Trading: What's True, What's False & What's Next
This week, the Securities and Exchange Commission (SEC) voted to propose rules that would require exchanges and broker-dealers who execute high frequency trades to provide trade information to a central repository in real time or near real time as a means for the SEC to better supervise trading activity. This proposal appears to be a result of the Dow Jones Industrial Average’s nearly 1,000 point drop on May 6 and a means for the SEC to better oversee the financial markets.
To many, high frequency trading remains a misunderstood and often unfairly-attacked subset of the investment industry. With this in mind, we’ve decided to take a closer look at what high frequency trading is and what the future may hold for this practice.
What is High Frequency Trading?
High frequency trading can be defined as the use of algorithm-based, quantitative-driven strategies to execute strategies with a holding time of less than one day. In other words, firms are trading in a rapid manner, while cutting holding fees and subsequently increasing profit margins.
More and more, traders are employing sophisticated computer technologies that allow them to quickly identify and execute pre-developed strategies across markets and move from position to position in just milliseconds. Furthermore, some high frequency trading shops are able to employ a strategy that relies on the ability to see certain orders a few milliseconds before the rest of the market. Firms use these “flash orders” to create micro-markets around a specific stock across exchanges.
The Major Players
There is a common perception that high frequency trading is reserved for the biggest and best investment firms – those who have virtually unlimited capital and resources. This assumption, however, is largely unfounded. While there are upfront capital requirements associated with high frequency trading, including technology, these infrastructure and applications costs will decrease over time. Alternatively, colocation offers firms a low-cost alternative to housing and maintaining their own infrastructure. Earlier this year, Securities Industry News took a closer look at how some firms are able to get the incubation and technology they need for high frequency trading.
Trends show that the majority of high frequency trading firms are located in New York, Chicago and London at the moment, while other regions continue to show continued growth, particularly Singapore, Sydney (AUS), South America and South Africa.
Strategy & Risk Management
When it comes to high frequency trading, there is no more important element for a firm than its strategy. Because high frequency trading is based heavily on speed, strategies are constantly changing, and firms should ideally be changing their strategies every few weeks to stay ahead of the competition.
One element of trading that has yet to be fully adopted is risk management. An effective risk management system should monitor a trader’s activity in real time and be able to identify when a trade exceeds risk boundaries set by the trader. (The now infamous stock market collapse on May 6, 2010 would have benefitted from the implementation of a more robust risk management system.)
Pre-trade risk management is affordable and easily available. So why aren’t high frequency trading firms utilizing it? The easy answer is that it takes time. Traders only have milliseconds to execute their strategies, but a risk management system can often add latency when it computes the firm’s risk profile. Eventually, traders may be forced to invest in risk controls as the investors and regulatory bodies like the SEC push for greater transparency across the markets.
What Does the Future Hold?
In the wake of the country’s economic meltdown and more recent stock market events, the SEC and other regulatory bodies have taken steps to better regulate the financial industry, including placing restrictions on high frequency trading.
Last year, the SEC proposed a ban on sponsored access, a process through which brokers give their level of access to high-speed traders, allowing them to buy and sell stocks without identifying themselves. The SEC’s fear is that such anonymous trading threatens market stability. But high frequency trading firms that use sponsored access maintain that it adds liquidity to the market.
There is still much debate over whether high frequency trading should be regulated, and there will likely continue to be until regulators like the SEC can clearly define what it is and how it should be monitored.
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