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High Frequency Trading

It could be the title of a Sherlock Holmes novel. The Hound of Hounslow describes how one man and his algorithm in West London allegedly managed to temporarily wipe $1 trillion of value from US stock markets in minutes. Welcome to the age of high frequency trading.

High frequency trading (HFT) is the science of market trading by highly sophisticated battling computers. Powerful supercomputers using complex algorithms analyse multiple market conditions and transact a very large number of orders at lightning fast speeds. It takes a computer about 10 microseconds to complete a transaction. If you were operating at that speed at the supermarket self-checkout, you could buy your entire lifetime grocery list in under a second (to the jangle of “please place the items in the bagging area”).

The impact that this technological wave has had on financial markets is nothing short of phenomenal. Most trades now originate from lines of computer code; high frequency trading is estimated to create 73% of all equity order volumes. In 1940 the average holding time of a stock was around 7 years; today it’s about 22 seconds. That gives a whole new meaning to market short-termism!

Speed and automation have their uses – some good, some less so. An investor with a large holding to sell, for example, would be ill-advised to dump all of their shares in one go. Instead they might use an algorithm to drip-feed that sell order into the market over time. Shrewder algorithms are attentive to the volume of other trades in the market, which can change throughout the day. In this way, the computers can sell when there are a lot of buyers.

Proponents of the algorithm argue high frequency trading improves liquidity, lowers transaction costs, and does not pose a systemic risk. However the abuses of high frequency are well documented. The fastest algorithm can know when an order is about to hit the books 30 millisecond before other market participants, and profit from that knowledge. This is front-running. There is a huge silent arms race amongst the prominent HFT firms of the world: the rewards for the quickest are huge. Meanwhile the exchanges, rather than removing these unfair advantages, instead purportedly get paid to allow firms to put their trading servers inside their exchanges to gain a speed advantage.

Next, enter the Hound of Hounslow. Or, to use his real name, Navinder Singh Sarao. In May 2010, Mr Sarao allegedly created $200m of fake sell orders, which were cancelled before execution, to dupe other computer algorithms to sell for real: this was the Flash Crash of 2010. The market dropped 6% and recovered in the space of half an hour (see chart below). Mr Sarao’s robots bought at the much lower price and made their creator a tidy fortune. This is not, alas, an isolated case: last summer a US firm was fined for sending 10,000 orders per second to the exchanges with few or no executions.

Ultimately, markets allow companies to raise investment finance and investors to allocate capital efficiently. There are clear advantages to high frequency trading, though the risks it introduces must be tempered to ensure markets can continue to fulfil their primary purposes. A parallel is the car; a fantastic invention, but sensible rules are necessary to prevent people getting hurt.

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