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High Frequency Traders (HFT) - Pushing For the Precipice

The rules of engagement in markets have changed and perhaps not for the better.

Pre the computer age market participants could look each other in the eye. Understanding who was buying and who was selling and why was straight forward. The raison d'etre of markets is to match the corporate world's need for capital with investors savings. Traders, trying to squeeze out a return from market trends, add to the liquidity in the secondary market.

The computer age added a new and, at first, welcome dimension. More data can be processed. Reporting speeds have increased. Costs have been reduced.

But bigger, ever faster, computers - supercomputers - with algorithm trading programmes have spawned a new breed of market participant, the high-frequency trader.

High-frequency traders (HFTs) operate as brokers or market makers and, as such, have similar direct access to the stock exchanges' order flows. They operate in the physical as well as derivatives and futures markets. In many cases, their powerful computers are located near to and even within stock exchange buildings providing them with a slight time advantage measurable in milliseconds.

But to a powerful computer that can react in milliseconds that is all the advantage the high-frequency trading firm needs to gain an advantage over all other market participants be they traders or investors.

What is becoming ever clearer, though, is that many of their activities exacerbate volatility in markets. Fear, greed and hope have always played their part in market activity making the markets more volatile than the underlying fundamentals warrant. But you can't change human nature and volatility is part and parcel of the markets.

But to deliberately set out to cause volatility with the aim of profiting from it seems against the basic principles of the market. One particular activity of the HFTs is the use of computerised trading programs that send out thousands of orders in milliseconds only to withdraw the same orders a millisecond later. The aim is to sniff out big institutional orders - buy or sell orders - and to then front run these orders scalping profits as they go.

High-frequency traders counter with the age old argument that they add liquidity to the markets and more liquidity is good. But the evidence is mounting that at times of stress their activities lead to the exact opposite - a collapse of liquidity. At times of market stress, other market operators, seeing a deluge of computer-driven sell orders, perhaps from several high-frequency traders using the same computer-driven algorithm programs, also move to sell and exit before prices decline even further. Selling begets selling.

Investigations by the SEC, the US markets regulatory body, after the 6th May 2010 flash crash, which saw the S&P 500 drop an unprecedented 9% in ten minutes, have highlighted the significant part played by HFT operators that day. Their impact on the 17% decline in the S&P 500 between 5th July and 8th August 2011 is also the subject of regulatory scrutiny.

To date, the SEC's investigations have found that buy orders simply dry up completely at times of stress and that the HFT operators fuel the fear required for this to happen. When a vacuum of buy orders develops, prices cascade downwards, not on increasing volume but on decreasing volume.

Some alterations to stock exchange order routing systems have been implemented, but high-frequency traders still dominate trading. Estimates of the proportion of business transacted on the US exchanges daily by HFTs are as high as 70%.

I might summarise as follows. Regulators appear to still be a long way behind the curve in understanding and dealing with this new 'Made in the USA market participant.

Firstly, without much greater restrictions on the activities of high-frequency traders, volatility in markets has probably been permanently raised. Indeed, the longer their activities go unrestricted the nearer we are to another market crash, not driven by fundamentals but by computer-driven programs capable of producing the conditions that often lead to blind panic by human participants. The mayhem witnessed on 6th May 2010 is unlikely to be the last such episode.

Secondly, with high-frequency traders scalping 'free' profits in markets it raises the costs for everyone else from retail investors to traders to pension and insurance company funds.

Thirdly, traditional stop-loss orders or sell-at-market orders carry higher risks now than previously. Recall that only orders that were executed at a price decline of 60% or greater were cancelled on 6th May 2010. In other words, ordinary investors or traders trying to protect positions with normal stop-loss orders would have been sold out on that fateful day at the first available price and could have lost up to 60% without an opportunity to buy back in. Some say that's a rigged market!

Lastly, the new participant does not appear to add to the proper functioning of markets. If a market participant is not interested in assessing the fundamental worth of a company or financial instrument and is not taking a risk while attempting to trade - which does add to market liquidity - that participant is not much more than a vulture. Let's hope the regulators get on top of the issue before we are faced with another flash crash. The Federal Reserve (US Central Bank) has spooked the markets in the past few weeks with talk of an end to quantitative easing. That's just the sort of uncertain backdrop into which high-frequency traders can inflict havoc.

Rory Gillen Founder GillenMarkets.com - Author 3-Steps to Investment Success