Known as HFT, High frequency trading involves using powerful computer programs to execute a large number of orders within fractions of a second. Using complex algorithms, it analyzes multiple markets and executes orders based on market conditions. A trader with the fastest execution speed is typically more profitable than one with a slower execution speed.
HFT is characterized not just by high order speeds, but also by high turnover rates and order-to-trade ratios. Virtu Financial, Tower Research, and Citadel LLC are some of the most well-known HFT companies.
High-Frequency Trading (HFT): An Overview
When exchanges started offering incentives to companies to make the market more liquid, HFT became popular. The New York Stock Exchange (NYSE) has Supplemental Liquidity Providers (SLPs) that attempt to add competition and liquidity to existing quotes on the exchange.
Liquidity was a major concern for investors following the collapse of Lehman Brothers in 2008. The NYSE offers a rebate or fee as an incentive for providing liquidity to companies. A large amount of profits is generated as a result of millions of transactions every day.
High-Frequency Trading (HFT) Benefits
HFT has improved market liquidity and reduced bid-ask spreads that previously would have been too small. HFT fees were added to test this, which caused bid-ask spreads to increase. The government introduced fees for high-frequency trading in Canada, which resulted in a change in bid-ask spreads. A market-wide increase of 13% was found in bid-ask spreads, whereas a 9% increase was found in retail spreads.
The High-Frequency Trading (HFT) Critique
A number of harsh criticisms have been leveled at HFT. The platform has replaced a number of broker-dealers and uses mathematical models and algorithms to make decisions, removing human interaction and decision-making from the equation.
The market moves in milliseconds, and this can result in big price swings without reason. The Dow Jones Industrial Average (DJIA) dropped 1,000 points and 10% in just 20 minutes on May 6, 2010, its largest intraday point drop ever. According to a government investigation, the crash was caused by a massive order that triggered a sell-off.
HFT is also criticized because it allows large companies to profit at the expense of the “little guys.” Its “ghost liquidity” can also be criticized as it appears on the market one second and is gone the next, preventing traders from executing their trades.
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