The beauty of creative destruction: why high-frequency trading is good for the markets

Robert Smith
October 13, 2021 | Hedging Insights

why high-frequency trading is good for the markets

If not a dirty word — well, phrase — high-frequency trading is, at best, controversial.


Critics argue it’s the stock market equivalent of cheating, usually at the expense of retail investors. The practice has also been blamed for the 2010 flash crash, when a 36-minute long collapse wiped 1000 points off the Dow Jones Industrial Average.


But does high-frequency trading actually deserve its bad reputation?


Not according to Rob Smith, an accomplished financial technologist who has worked with the likes of Knight Capital Group and GETCO before founding Applied Financial Technology, a company that develops automated trading and risk management software.


In a recent episode of our Talking Hedge podcast, we sat down with him to discuss the origin and evolution of high-frequency trading and the reasons why it’s actually a good thing.

What is high-frequency trading?

High-frequency trading is the practice of using powerful computers to execute trades in at high speed and thus in large volumes. First, algorithms analyse the markets. Then, they execute orders based on that analysis.


To succeed at high-frequency trading, accuracy and speed are critical. Algorithms’ mathematical models need to be sophisticated enough to identify market conditions with reasonable certainty. And they must be able to do it as quickly as possible.


The whole process — from analysis to execution — usually takes milliseconds. But the traders who are most profitable are typically those who can execute orders the fastest. Even a nanosecond makes a difference.


High-frequency trading became popular when exchanges started incentivising institutions that add liquidity to the markets. Island Exchange, for example, was an early mover and was followed by others including the New York Stock Exchange, which pays fees and rebates to traders who qualify as Supplemental Liquidity Providers.


The reasoning went something like this.


Passive liquidity on exchanges makes it easier for the average investor to cash out their stocks or other assets without hurting their market price.


So, by giving high frequency traders a reason to keep doing what they’re doing, everybody wins. The markets are more liquid, investors can unlock the value in their assets more easily, and high-frequency traders increase their profits.


The incentives worked. Today high-frequency trading makes up about 60% of the trades on US equity markets and around 30% on the UK and EU markets.

So why the bad rep?

Critics of high-frequency trading have three main arguments:


  • It gives large institutions, who have more capital and resources, an unfair advantage over smaller players, especially retail investors
  • It’s unethical
  • Even if high-frequency trading adds liquidity to the markets, nobody gets to benefit from it, because it’s gone just as quickly as it appears


Let’s have a more in-depth look at these arguments.

'The market is rigged'

In Flash Boys: A Wall Street Revolt, financial journalist and author Michael Lewis argues that the problem with high-frequency trading is that the technology is open to misuse.


Before there were computer algorithms, notes Lewis, we executed orders on the trading floor, which evened the playing field. But now that trading has become a series of electrical signals routed through data centres, that’s no longer the case.


Professor Jonathan Macey likens the situation to a motorcyclist who notices an HGV trundling along the motorway. The motorcyclist knows the HGV will have to refuel sometime. So they speed ahead, buy up all the petrol, and sell it to the HGV driver at a premium.


Similarly, Brad Katsuyama — a central figure in Lewis’ book — argues that high frequency traders ‘…know the horse race is over, and they’re betting against people who still think the race is happening.’


In other words, the outsize profits are mainly due to the speed at which high-frequency traders can exploit imbalances in supply and demand, not fundamentals like the underlying assets’ future prospects.

The phantom menace

The second line of argument against high-frequency trading is that its key benefit — pouring added liquidity into the markets — is exaggerated.

High frequency traders place huge numbers of orders on a daily basis, but they cancel them just as quickly. Lewis and other critics argue that this practice creates ghost liquidity or phantom liquidity. It inflates supply or demand and manipulates the market in high-frequency traders’ favour.

Says Lewis:

‘​​By the summer of 2013, the world’s financial markets were designed to maximise the number of collisions between ordinary investors and high frequency traders at the expense of ordinary investors and for the benefit of high frequency traders, exchanges, Wall Street banks, and online brokerage firms. manipulating the market in their favour.

'I ain't 'fraid of no ghost'

A 2016 Vanderbilt University study which looked through a 5.78-terabyte dataset of message activity on S&P 500 stocks has debunked the ghost liquidity argument.


Phantom liquidity,’ says lead researcher Jesse Blocher ‘can only be a problem if those who cannot get good execution find the price moving against them when they try to trade. We do not find that in our data.


Far from being manipulative, the study found that the practice of placing and then cancelling large numbers of orders has another purpose: ‘…liquidity providers have simply replaced low frequency market makers with lower cost price discovery.’


In the vast majority of cases, the study concludes, bid and ask prices quickly revert to pre-cancellation levels. Which means nobody is being manipulated into trading at an artificial price.

What's wrong with innovation?

So far so good.


But what about the claims of questionable ethics and unfairness?


According to Rob Smith, the problem with these arguments is that they misconstrue innovation as unfair competition.


If you go back 2,500 years,’ he says, ‘you had Greek merchants who’d go to the hillside to see how heavily laden with goods incoming ships were. If there’s a lot of supply coming in, maybe you lower your prices. If ships are very light, you raise them.


Fast forward 2,400 years, and you’ve got Baron Von Reuter (as in Reuters News Service, now Thomson-Reuters) using carrier pigeons to get financial news between Berlin and Paris… and telegraphing London about US ships’ cargo…’


The inference is that high-frequency trading isn’t a new thing. People have always understood the value of acquiring information and acting on it fast. In 2500 BCE, the best technology available for this was to stand on a hillside and use your eyes and ears.


Now, we have computer algorithms.

There's no reward without risk

To buttress the unfairness argument, critics of high-frequency trading often point to high profits as if they somehow prove ill-intent.


But what they conveniently overlook, notes Smith, is the huge amount of investment setting up a high-frequency trading operation entails.


I don’t think you could start a firm today without a couple of hundred million in capital,‘ he says, ‘because you need the data centers, you need the lines, you need the hardware.


Needless to say, nobody would go through this trouble and expense if there wasn’t an opportunity to profit.


People ask: “Well, how much profit are they making?” But why is that unfair? The whole point of business is that you take resources like capital, technology, and people and do something productive with them.


I don’t think the profit is outsized at all… They took a massive risk. They put their own capital on the line. It’s not an unfair situation.

Creative destruction is a boon for consumers in every industry. Why stifle it?

Whenever groundbreaking technology comes along, it’s either ridiculed or reviled.


But history soon proves naysayers wrong.


Aeroplanes are critical to the modern day supply chain. But at the time the Wright Brothers conducted the first flight, they were dismissed as ‘interesting scientific toys…’ of not much practical value.


Similarly, most of us couldn’t live without our smartphones today. But when personal computers came out in the early 1980s, computer-phobia was rampant.


Smith reckons the same is bound to happen with high-frequency trading.


Mistrust of new technology is normal, especially when the few are making large profits off it. But once technology is no longer a novelty, first-mover advantages like high profits are competed away. And, ultimately, everyone benefits.


Let’s travel back to 1847,’ concludes Smith. ‘Something happened in Berlin and news was forwarded by carrier pigeon. The pigeon is faster than the train. But by the time somebody’s making a decision two days later, the world has moved on.


This is just as true on a day by day, hour by hour, microsecond by microsecond basis. You always have the risk of making wrong decisions based on old information. Very sensibly, what you need to do is to get that information and process that information as fast as you possibly can.’


And if you can make better-informed decisions more quickly, it lowers risk and, in turn, costs for the entire marketplace.


No, there’s nothing nefarious going on with high-frequency trading.


Listen to the Talking Hedge episode to learn more about how high-frequency trading works and hear Rob set the record straight

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Robert Smith