High Frequency Trading: Problems & Solutions

Written by: Anisah Khan

The Bank of England press briefings on the 19th Dec 2019 discussing ‘Global risks to the UK’s financial stability’ were reported by The Times to have been hijacked through a secret feed, giving third-party Hedge Fund clients early access to the information released at the press conference. The audio was 5 to 8 seconds ahead of the video feed provided by Bloomberg. Gaining the information at Mark Carney’s address first, allowed Hedge Fund managers to analyse and make decisions on funds before the information was publicly known, giving the clients an advantage.

Following the security breach, UK’s financial watchdog the Financial Conduct Authority launched an investigation into the events that led to the misuse of the audio feed at Threadneedle Street. A spokesperson at the Bank of England has confirmed the issues and stated it was a ‘wholly unacceptable use of the audio feed without the Bank’s knowledge or consent and is being investigated further’. Although it was a third party carrying out the misconduct, the security of the Bank of England has been questioned.

The question arises whether this could be classed as a form of insider trading, an illegal practice where information is not publicly available is obtained and used to one’s advantage in the stock market. Obtaining information before competitors is crucial for trading firms and firms have been taking this to new heights, particularly since the early 2000s. Firms opt for methods such as using faster fibre optic cables to gain an advantage over the traditional methods of communication and information gathering used by most firms, allowing users to see other buyers’ orders before they are executed. This type of trading is called High Frequency Trading (HFT), where complex algorithms analyse multiple markets and breaking news articles to engage in a high volume of orders in a short period of time, gaining large amounts of profits due to the sheer volume. Fundamentally, HFT is legal and trading firms who utilise it applies the similar strategies to other trading firms, the primary difference is the speed and frequency in which it executes trades. The question is, where do we draw the line? To understand this, we must review the essence of HFT. This article shall explore the risks and challenges presented by HFT and how these could potentially be addressed over the coming years.

HISTORY

High frequency trading has been around since the 1930s, however it was only recently that it became the high-speed and high-volume trading that we categorise as HFT now. In early 2009, 827 miles of cable costing an estimated $300m (Forbes) was constructed to connect a data centre from Chicago to New Jersey. This project was to be carried out in absolute secrecy to avoid competition. The cable was to be kept straight as possible resulting in many a mountain drilled through; all to enable the client to cut a fraction of a millisecond off the standard communication time. This allowed visibility and communication to be fractions of seconds ahead of traditional systems, with clients able to act on the best possible course of action, prior to the rest of the market gaining the information.

When the idea of faster communication became more widespread, firms began to pay millions of dollars to move their data server closer to the exchange to shorten the length of the cable, speeding up processes by even just microseconds making a difference. NYSE partially combated this absurdity by ensuring all cables were exactly 185 yards for every server. However, this still did not fully eliminate the conflict as traders realised that coiled up cable transmits data a few billionths of a second slower than straight cable, and so the war of location of servers did not end there.

HFT’s market share grew significantly, as the method was not only very profitable, but also relatively low risk as super-computers could place orders before the competition. At its peak, HFT volumes accounted for over 60% of the market in 2010, however this was soon to change as the aftermath of financial crisis began to take its toll.  The volume of HFT declined, as margins became slimmer and the opportunity seen in prior years had become limited with a crowded marketplace. In 2017, only under half of equity volume was traded through HFT.

CRITICISMS & RISKS /DECLINE & THE FLASH CRASH OF 2013

Supporters claimed that added liquidity in that market from a large number of HFT trades could benefit even individual traders, whilst critics suggested that the liquidity produced is only momentary, and therefore impossible to take advantage of in real terms. Tough market conditions and the sheer volume needed to compete with the few large institutional players caused smaller firms to be taken over by them, limiting competitive rivalry and stagnating the revenue opportunities that were previously available. Alongside this, Italy became the first country to introduce taxes on HFT trading, followed by others and when added to the cost of technology and infrastructure, it became less profitable.  

Another impact of HFT flash crashes, where speed is key to causing values to decline dramatically as result of rapid selloffs of securities. In May 2010, trillions of dollars of equity disappeared, with the Dow Jones Industrial Average falling more than 1000 points in 10 mins. By the end of the day however, the market regained 70% of its value. HFT backers argue that HFT was the reason the market was able to recover so quickly, and traditional traders would never possess the same speed of resilience, thus causing turmoil and economic instability. The crash was later attributed to a trader based in Hounslow London, UK who was charged on 22 counts of fraud and sentenced to 380 years for ‘spoofing’ by quickly buying and selling hundreds of E-mini S & P Futures contracts. Many have questioned whether this alone triggered the crash, or if HFT was the underlying cause.

The Flash Crash highlighted the way our financial systems were managed; majorly influenced by machines and algorithms humans were not in control of and did not fully understand. This brings about the reality of our world, with humans handing over control to computers of the financial system upon which everything a capitalist society relies. The ability for a single glitch in an algorithm to devalue and result in a collapse of the system would likely result in catastrophic effects and ripples throughout society through stocks, currencies and key services such as oil, goods, utilities etc. without any hope of revival as intervention by humans would not be possible when the problems in code are not entirely understood. For example, a glitch causing a devalued stock of a company employing a significant proportion of the nation or of an entire countries currency would devastate not only those directly affected, but also indirectly affect the global economic system.

POTENTIAL SOLUTIONS

In trying to solve the issues with HFT, taking a step back into the traditional market framework would only exacerbate the problem. In 2018 Go West, a joint venture of six trading firms, is building fibre-optic and undersea cables to connect to only US data centres but also routes from Chicago to Tokyo. Wall Street is no longer the hub of trading of the past, it relocated to the west of the US and is now on a global scale. This demonstrates the shift from the competing firms seen in the past during the beginnings of HFT. Now, a joint effort to aim for speed of light communication is taking place – thereby eliminating competition as the light barrier cannot be passed; thus, every firm will trade at the same speed.

Another solution is to ensure the exchange provides an equal opportunity. A prominent financial author, Michael Lewis wrote ‘Flash Boys: A Wall Street Revolt’ in 2014 which brough HFT into the limelight. It detailed the journey of the founders of Investors’ Exchange, IEX – which was founded in 2012 to eliminate dubious practices in the market such as dark pools and level the playing field by ensuring data arrives simultaneously to all traders.

Following the Flash Crash in 2010, regulation in the EU and US has tightened and introduced circuit breakers to prevent such occurrences, however glitches and errors have become even more frequent leading to increased market volatility. UK law has introduced provisions to guard against the worst risks of HFT, however specific taxes like those in force in European countries are not currently in place within the UK.

CONCLUSION

All in all, HFT is practiced within financial markets globally and algorithmic trading based on computers is now commonplace. Stronger regulatory frameworks and technological advancements will ensure better understanding of the systems in place, allowing control to be exercised over the marketplace and therefore enabling fairer trading practices and less volatility, making the financial platforms and therefore the economy more stable.

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