Should You Care About High-Frequency Trading?

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The media, from Barron’s to The Daily Show, has been discussing high-frequency trading since the release of Michael Lewis’s Flash Boys and regulators recently initiated investigations into the practice. Regular investors are left wondering what the excitement is about and if it affects them. Below are six basic questions, answered, about high-frequency trading.

What is high frequency trading?

High frequency trading “HFT” is an investment strategy using advanced computer programs to rapidly buy and sell securities. Generally trading on fractions of pennies over the course of milliseconds, HFT started in 1999 after the Security and Exchange Commission “SEC” allowed electronic exchanges. The latency in the time it took for information to be transmitted to different markets was soon observed and firms began trading based on the data.

What is dark liquidity?

Dark liquidity and dark pools are both terms for alternative trading platforms, where a trade is made without general investor knowledge until completion. This method is advantageous to investors who want to trade large blocks of securities without affecting the publicly traded quote. Trading is through either a direct deal or a program that buys and sells without sending the order to the stock exchange. In his book, Lewis accuses banks of selling their clients’ information to HFT firms, who then analyze and trade on the data.

Why is this a big deal?

Trades on fractions of pennies are meaningless on their own, but compounded billions of times and they potentially skew the market. As Forbes reported in an interview with industry insiders, HFT accounted for half of all trading in 2012, down from 61 percent in 2009. A study released by the SEC concluded that HFT was found to be a significant contributor to 2010’s “flash crash,” when the Dow Jones dropped and regained 1,000 points, or 9 percent, within minutes due to a single trader. In 2012, one computer made up 4 percent of that week’s total market volume as it created and cancelled orders in 25 millisecond increments. Proponents of HFT believe that the trading strategy is beneficial to the market’s overall liquidity, although there are conflicting studies on this theory.

According to a report released by the Chicago Federal Reserve, HFT affected the start of Facebook’s IPO trading, causing some to not know if they had successfully bought shares. UBS (NYSE:UBS) lost over $350 million because of the hiccup. Dark liquidity’s trading volume was hinted at on February 10, when a glitch in the reporting system revealed 40 percent of all listed stocks had gone through an alternative trading platform first.

Who handles these trades?

HFT is generally done through specialized firms. One of the largest alternative trading platforms is Sigma X, run by Goldman Sachs (NYSE:GS). The Wall Street Journal reported that the investment bank is considering closing Sigma X due to criticisms, but no decision has been made. Although it has operated Sigma X since 2006, Goldman Sachs has made it clear that they are open to a more transparent system and supports new trading platform IEX, which would institute a 350 microsecond delay. Gary Cohn, president and COO of Goldman Sachs, wrote an op-ed piece in The Wall Street Journal calling for more HFT oversight.

While not directly involved, Bank of America (BAC) was the darling of HFT firms during 2012, where 4bn of its stock was traded on an average day. This was attributed to the amount of stocks Bank of America offers, nearly three times more than any other large bank. Bank of America itself has no stated opinion on HFTs, but Bill Harts, former CEO for Bank of America Specialists, has recently spoken against the practice.

What’s being done?

As the information being traded is public, no current laws have been broken. Until recently, there has been little regulatory oversight, partially due to the difficulty monitoring high speed transactions. The NY Post reported that the SEC is getting ready to crack down on HFT firms and enforce regulation as well as new practices. Last month, NY Attorney General Eric Schneiderman opened an investigation into HFTs and dark pools. The FBI has also initiated a probe.

Does it affect me?

In the case of alternative trading platforms, by the time a stock’s price is public, it could no longer be relevant. On a trade-by-trade basis, HFT mostly affects the larger banks trading on high volumes. Depending on the outcome of the state and federal investigations, the probes could result in an overhaul of trading strategies, although it is unclear if any changes would affect the average investor.

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