We speak more and more often of High Frequency Trading or, in English, High Frequency Trading (HFT) probably because this activity is considered one of the scapegoats of the increasingly common tumbles of the financial markets.
But who are High Frequency Traders? We are talking about companies that carry out purchase and sale operations in an automatic and pushed way, especially on shares and futures, exploiting small imperfections in the markets. The High Frequency Trading software captures a microscopic price difference on the same stock listed on two different Stock Exchanges and, in a fraction of a second, buys the stock where it costs less, immediately reselling it where it costs more.
Thus a very small profit is obtained which, multiplied by a very large number of operations, makes a nice nest egg. Obviously this activity involves large operating volumes. All this automatically, without human intervention (the HFT execution times are not within human reach!). How much do these operations affect in terms of volumes? Suffice it to say that in forty years the average holding period of a security in the hands of an investor has gone from a month (which by my standards is already a ridiculous amount of time) to a few milliseconds!
Nothing bad so far: it is arbitrage, which has a fundamental function on the financial markets, similar to that performed in nature by large predators: they feed on the weakest animals, contributing positively to the evolution of the species. Furthermore, High Frequency Traders are always very active and ready to be the counterparty of those who want to buy or sell something: therefore, in principle, they would improve the liquidity of the market.
This feel-good thesis, namely "HFT decreases volatility and increases market liquidity", is obviously the favorite of those who, in the financial industry, practice HFT ... but what do the "regulators" think about it? ”, that is, those who oversee the correct functioning of the markets?
In a joint report, the US SEC (the equivalent of our Consob) and the Commodity Futures Trading Commission declared that "HFT very rapidly amplifies the effects of operations carried out by other operators, such as mutual funds". In this way, from the seed of a sales operation that starts from a fundamental evaluation of a traditional operator, a cascade of sales with a ruinous effect can arise.
On September 22, 2010 SEC Chairman Mary Schapiro stated: “…HFT has a tremendous ability to affect the stability and integrity of financial markets“. In fact, companies that practice HFT, which on peak days are responsible for around 80% of trades, (literally) flood the market with "immediate or cancel" type orders: orders which, if not executed immediately, are canceled . These orders are not normally filled (on average 1 in 100 orders are filled) and so are just "noise" to other traders. Other than liquidity…
With this "spamming" of phony orders, HFT companies probe the market, a bit like sonar: they generate an action to trigger a reaction. Thus, they manage to reconstruct the picture of the situation and put themselves in a position to financially devour the small day-traders, practically anticipating them. Note that HFT also operates on Borsa Italiana: so be careful, if you trade you could be an easy meal for these predators!
Not only the little ones suffer. Large institutional investors, such as pension funds or mutual funds, tend to divide the transaction into smaller tranches when buying or selling a security. In these cases, the High Frequency Traders, bombarding the system with their evanescent "probe orders", manage to sneak in front of the orders of the other investors (also thanks to their physical proximity to the Stock Exchange and privileged communication channels), doing what slang is called “front running”. So, if the pension fund you invest in for your retirement is buying a stock, the High Frequency Trader skips the queue, buys the stock a moment earlier and then immediately sells it back to the pension fund at a higher price. It goes without saying that this is not good for the pension fund and for those who have linked their pension future to it.
Nanex, a company that deals with data, research and financial analysis, has found that in recent years HFT has increased operating costs, significantly reducing market efficiency (for those wishing to learn more, here is the Nanex study, very technical but very detailed). The underlying idea is that the millions of bogus orders (some even dub them “toxic orders”) are just financial spam and don't really improve the liquidity of the markets.
Then there is the issue of the instability of the software used. Anyone who seriously deals with software knows that there is no code without bugs… now, if we consider that HFT operates in a totally automated way, with crazy volumes, it is quite evident that any problems in the code can have a devastating impact on the markets which, due to their high level of interconnection, tend to propagate the shock at very high speed. The extremely high competitive pressure to which HFT companies are subjected means that software development is based more on speed than rigor. So the problem of bugs and out of control software exists and is critical, as it has already occurred several times, for example in "Knightmare".
Although I am a quant by training, naturally in favor of systematic methods that apply formal rules to investing, my very personal opinion on HFT (which constitutes a subset of algorithmic methods) is profoundly negative. The bottom line is that High Frequency Trading algorithms have a tremendous impact on the market in terms of volume, are potentially unstable and ultimately increase systemic risk. It's a quantity problem: HFT affects too much. Machines have indeed increased human capabilities in every field, but here they only increase the probability of causing market crashes worse than the "Black Monday" of 1987.
A very negative aspect is that, with their predatory practices, HFTs destroy the trust of other investors. Even if, it must be said, those who invest based on fundamentals with a long-term perspective and low portfolio movements (exactly the approach of the Advise Only portfolios), are relatively immune from the effects of High Frequency Trading: in this case the decisions of portfolio travel on another financial wavelength, much longer. How to wipe out High Frequency Trading from the markets? A modest Tobin Tax applied worldwide.
