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Experts unsure of effects of high-frequency trading

By Theodore Terpstra
On April 10, 2014

Last week, William O'Brien, CEO of BATS, and Brad Katsuyama, CEO of IEX, an alternative market, argued live on the air about the impact of high-frequency trading on the markets. Reports say that traders on the floor of the NYSE stopped trading and were temporarily distracted by the energetic debate, which was broadcast live on CNBC to televisions on the NYSE trading floor. The debate stemmed from the recent release of the book, "Flash Boys" by Michael Lewis, in which Lewis writes that high-frequency traders rip off investors. High-frequency trading has been the subject of debates for years. While some believe high-frequency trading improves the quality of markets, others are more critical of the practice. Among the main criticisms of high-frequency trading is that it makes the market more volatile and cheats investors who are slower at trading.
As evidence of the impact of high-frequency trading on market volatility, some point to "flash crashes," most notably the flash crash in May 2010. But the facts do not support this accusation; a report from the Securities and Exchange Commission said the main cause of the flash crash was the sale of billions of dollars in futures by a non-HFT trader. The benefit in high-frequency trading is that it can react quickly to rapidly developing situations in markets. While some HFTs pulled their orders during the flash crash, others continued to trade. Those that did pull their orders did so out of confusion over whether the trades were valid. The Securities and Exchange Commission recommended that better guidelines be set in order to establish what trades are valid.
High-frequency trading can actually improve market quality because it ensures prices between related markets are aligned. The quick and efficient trading corrects any price discrepancies that emerge. Proponents of HFT also argue that everyone benefits. Long-term buy-and-hold investors who seem unlikely to benefit from HFT actually do benefit from reduced transaction costs. Meanwhile, professional traders use HFT as a risk management tool, changing orders as the latest information on market conditions arrives. While HFTs change the quality of markets, they also dramatically impact the quantity of trades in a market. The increase in volume of trade can be harmful to traders because it also increases their expenses.
The debate over the pros and cons of HFTs has been argued again and again for years. Even though HFTs were not directly responsible for the 2010 flash crash and the majority of investors can stand to benefit from HFTs, there still is controversy. Ultra-fast trading algorithms have come under scrutiny in recent years because many believe that the government is not doing enough to regulate this kind of trading. The lack of regulation leaves potential for abuse. One proposed solution would be a tax on HFTs in addition to providing government regulators with the tools they need to conduct electronic audits. Recently the FBI began investigating some high frequency traders over insider trading, wire fraud and securities fraud. The FBI has appealed to anyone with knowledge of misdeeds to come forward. If regulators had better oversight, the FBI would not have to rely on whistleblowers coming forward with evidence of misconduct. Instead of depending on a paper trail, authorities could also track the electronic trail left by trades.
The Securities and Exchange Commission has stated that it lacks enough data to know exactly what impact HFTs have had on the market. Still, there is an obvious lack of oversight. High-frequency trading needs closer regulation so that violators who abuse these tools are caught. The modern markets of today are much more vulnerable to abuse than the markets of the past, where electronic trading played far less of a role. While it is clear that HFTs do not cause flash crashes, such as the one that occurred in May of 2010, it is still possible that HFTs can contribute to future crashes.
 


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