The Social Value of High Frequency Trading

Asad Dossani
High Frequency Trading (HFT) is a form of algorithmic trading. HFT uses computer programs to execute trades at high speeds. Often, trades are held for just a fraction of a second. HFT is most common in the U.S., where it is estimated that over half the stock exchange volume comes from HFT. But it is also common in India. Around one third of trading volume in the Indian stock exchange comes from HFT.

Is HFT good or bad for financial markets? Most financial regulators are still working to find the answer. On the positive side, HFT has been shown to improve liquidity and reduce trading costs. On the negative side, it leads to flash crashes and higher volatility. HFT firms have an unfair advantage at the expense of investors. In Michael Lewis' book Flash Boys, this is examined in detail.

Who are the winners and losers from HFT? The first obvious loser is the market maker. Individual market makers are outmatched in terms of speed by HFT. It is increasingly the case that market making is now done mostly by computers rather than individuals. Other short term traders lose out too. Traders with very short holding periods are competing directly with the high frequency traders. They inevitably lose out.

While short term traders suffer, traders with longer holding periods benefit. On the basis that HFT reduces bid offer spreads, this reduces transaction costs for all traders and investors. Since long term traders and investors do not directly compete with HFT, they gain from the lower transaction costs.

One caveat here is that it is not definitive that HFT reduces trading costs. In normal market conditions, HFT clearly reduces trading costs. But during market crashes and panics, this isn't necessarily the case. Unlike a traditional market maker, HFTs have no obligation to provide liquidity to the market. This increases the risk of low liquidity during a market crash.

The biggest criticism of HFT is that it can actually cause market crashes and increased volatility. Various flash crashes in recent years have been attributed to HFT. Increased instability in markets is bad for everyone. We have all seen what happens when markets become extremely volatile.

On the whole, there is no consensus as to whether HFT has positive social value? Many regulators increasingly believe that HFT is bad for markets, and are taking steps to discourage it. Partly, this is due to the perception that HFT firms have an unfair advantage over other market participants.

Unfairness is a bigger problem than it seems. If other market participants believe that the market is rigged against them, then they will not trade. And in the long run, social value is destroyed.

Time will tell whether HFT is good or bad for markets. But for now, it is here, and we need to be aware of it. As a trader, what is the best way to deal with the existence of HFT? As I mentioned, HFT creates winners and losers. Next time, I'll tell you how to be one of the winners.

Do you think HFT is good or bad for markets? Share your views in the Club or share your comments here.

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1 Responses to "The Social Value of High Frequency Trading"
Subramanian Ram
26 Dec, 2014
HFT or Algorithmic trading is already intoduced in the markets & there is no point in debating the merits or demerits of the system. It is a great disadvantage to small companies & traders who cannot afford to invest & have such systems.It is impossible to compete against HFT. The real risk is it may trigger a system driven spike in the markets without any underlying fundamental factors causing extreme volatility in the markets.The exchanges should take abundant precautions and prevent such occurences which is not good for the markets.Like (1)
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