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High-frequency trading (HFT) is a type of algorithmic financial trading characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools.[1] While there is no single definition of HFT, among its key attributes are highly sophisticated algorithms, co-location, and very short-term investment horizons.[2] HFT can be viewed as a primary form of algorithmic trading in finance.[3][4] Specifically, it is the use of sophisticated technological tools and computer algorithms to rapidly trade securities.[5][6][7] HFT uses proprietary trading strategies carried out by computers to move in and out of positions in seconds or fractions of a second.[8] In 2017, Aldridge and Krawciw[9] estimated that in 2016 HFT on average initiated 10–40% of trading volume in equities, and 10–15% of volume in foreign exchange and commodities. Intraday, however, proportion of HFT may vary from 0% to 100% of short-term trading volume. Previous estimates reporting that HFT accounted for 60–73% of all US equity trading volume, with that number falling to approximately 50% in 2012 were highly inaccurate speculative guesses.[10][11] High-frequency traders move in and out of short-term positions at high volumes and high speeds aiming to capture sometimes a fraction of a cent in profit on every trade.[6] HFT firms do not consume significant amounts of capital, accumulate positions or hold their portfolios overnight.[12] As a result, HFT has a potential Sharpe ratio (a measure of reward to risk) tens of times higher than traditional buy-and-hold strategies.[13] High-frequency traders typically compete against other HFTs, rather than long-term investors.[12][14][15] HFT firms make up the low margins with incredibly high volumes of trades, frequently numbering in the millions. A substantial body of research argues that HFT and electronic trading pose new types of challenges to the financial system.[5][16] Algorithmic and high-frequency traders were both found to have contributed to volatility in the Flash Crash of May 6, 2010, when high-frequency liquidity providers rapidly withdrew from the market.[5][15][16][17][18] Several European countries have proposed curtailing or banning HFT due to concerns about volatility.[19] History Strategies Effects Edit The effects of algorithmic and high-frequency trading are the subject of ongoing research. High frequency trading causes regulatory concerns as a contributor to market fragility.[52] Regulators claim these practices contributed to volatility in the May 6, 2010 Flash Crash[58] and find that risk controls are much less stringent for faster trades.[16] Members of the financial industry generally claim high-frequency trading substantially improves market liquidity,[12] narrows bid-offer spread, lowers volatility and makes trading and investing cheaper for other market participants.[61] An academic study[35] found that, for large-cap stocks and in quiescent markets during periods of "generally rising stock prices", high-frequency trading lowers the cost of trading and increases the informativeness of quotes;[35]:31 however, it found "no significant effects for smaller-cap stocks",[35]:3 and "it remains an open question whether algorithmic trading and algorithmic liquidity supply are equally beneficial in more turbulent or declining markets. ...algorithmic liquidity suppliers may simply turn off their machines when markets spike downward."[35]:31 In September 2011, market data vendor Nanex LLC published a report stating the contrary. They looked at the amount of quote traffic compared to the value of trade transactions over 4 and half years and saw a 10-fold decrease in efficiency.[62] Nanex's owner is an outspoken detractor of high-frequency trading.[63] Many discussions about HFT focus solely on the frequency aspect of the algorithms and not on their decision-making logic (which is typically kept secret by the companies that develop them). This makes it difficult for observers to pre-identify market scenarios where HFT will dampen or amplify price fluctuations. The growing quote traffic compared to trade value could indicate that more firms are trying to profit from cross-market arbitrage techniques that do not add significant value through increased liquidity when measured globally. More fully automated markets such as NASDAQ, Direct Edge, and BATS, in the US, gained market share from less automated markets such as the NYSE. Economies of scale in electronic trading contributed to lowering commissions and trade processing fees, and contributed to international mergers and consolidation of financial exchanges. The speeds of computer connections, measured in milliseconds or microseconds, have become important.[64][65] Competition is developing among exchanges for the fastest processing times for completing trades. For example, in 2009 the London Stock Exchange bought a technology firm called MillenniumIT and announced plans to implement its Millennium Exchange platform[66] which they claim has an average latency of 126 microseconds.[67] This allows sub-millisecond resolution timestamping of the order book. Off-the-shelf software currently allows for nanoseconds resolution of timestamps using a GPS clock with 100 nanoseconds precision.[68] Spending on computers and software in the financial industry increased to $26.4 billion in 2005.[69] May 6, 2010 Flash Crash Edit Main article: 2010 Flash Crash The brief but dramatic stock market crash of May 6, 2010 was initially thought to have been caused by high-frequency trading.[70] The Dow Jones Industrial Average plunged to its largest intraday point loss, but not percentage loss,[71] in history, only to recover much of those losses within minutes.[72] In the aftermath of the crash, several organizations argued that high-frequency trading was not to blame, and may even have been a major factor in minimizing and partially reversing the Flash Crash.[73] CME Group, a large futures exchange, stated that, insofar as stock index futures traded on CME Group were concerned, its investigation had found no support for the notion that high-frequency trading was related to the crash, and actually stated it had a market stabilizing effect.[74] However, after almost five months of investigations, the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) issued a joint report identifying the cause that set off the sequence of events leading to the Flash Crash[75] and concluding that the actions of high-frequency trading firms contributed to volatility during the crash. The report found that the cause was a single sale of $4.1 billion in futures contracts by a mutual fund, identified as Waddell & Reed Financial, in an aggressive attempt to hedge its investment position.[76][77] The joint report also found that "high-frequency traders quickly magnified the impact of the mutual fund's selling."[17] The joint report "portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral", that a large mutual fund firm "chose to sell a big number of futures contracts using a computer program that essentially ended up wiping out available buyers in the market", that as a result high-frequency firms "were also aggressively selling the E-mini contracts", contributing to rapid price declines.[17] The joint report also noted "HFTs began to quickly buy and then resell contracts to each other – generating a 'hot-potato' volume effect as the same positions were passed rapidly back and forth."[17] The combined sales by Waddell and high-frequency firms quickly drove "the E-mini price down 3% in just four minutes".[17] As prices in the futures market fell, there was a spillover into the equities markets where "the liquidity in the market evaporated because the automated systems used by most firms to keep pace with the market paused" and scaled back their trading or withdrew from the markets altogether.[17] The joint report then noted that "Automatic computerized traders on the stock market shut down as they detected the sharp rise in buying and selling."[54] As computerized high-frequency traders exited the stock market, the resulting lack of liquidity "...caused shares of some prominent companies like Procter & Gamble and Accenture to trade down as low as a penny or as high as $100,000".[54] While some firms exited the market, high-frequency firms that remained in the market exacerbated price declines because they "'escalated their aggressive selling' during the downdraft".[15] In the years following the flash crash, academic researchers and experts from the CFTC pointed to high-frequency trading as just one component of the complex current U.S. market structure that led to the events of May 6, 2010.[78] Granularity and accuracy Risks and controversy Edit According to author Walter Mattli, the ability of regulators to enforce the rules has greatly declined since 2005 with the passing of the Regulation National Market System (Reg NMS) by the US Securities and Exchange Commission. As a result, the NYSE's quasi monopoly role as a stock rule maker was undermined and turned the stock exchange into one of many globally operating exchanges. The market then became more fractured and granular, as did the regulatory bodies, and since stock exchanges had turned into entities also seeking to maximize profits, the one with the most lenient regulators were rewarded, and oversight over traders' activities was lost. This fragmentation has greatly benefitted HFT.[80] High-frequency trading comprises many different types of algorithms.[1] Various studies reported that certain types of market-making high-frequency trading reduces volatility and does not pose a systemic risk,[12][59][60][74] and lowers transaction costs for retail investors,[15][35][59][60] without impacting long term investors.[6][12][60] Other studies, summarized in Aldridge, Krawciw, 2017[81] find that high-frequency trading strategies known as "aggressive" erode liquidity and cause volatility. High-frequency trading has been the subject of intense public focus and debate since the May 6, 2010 Flash Crash.[85] At least one Nobel Prize–winning economist, Michael Spence, believes that HFT should be banned.[86] A working paper found "the presence of high frequency trading has significantly mitigated the frequency and severity of end-of-day price dislocation".[87] In their joint report on the 2010 Flash Crash, the SEC and the CFTC stated that "market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets"[75] during the flash crash. Politicians, regulators, scholars, journalists and market participants have all raised concerns on both sides of the Atlantic.[30][84][88] This has led to discussion of whether high-frequency market makers should be subject to various kinds of regulations. In a September 22, 2010 speech, SEC chairperson Mary Schapiro signaled that US authorities were considering the introduction of regulations targeted at HFT. She said, "high frequency trading firms have a tremendous capacity to affect the stability and integrity of the equity markets. Currently, however, high frequency trading firms are subject to very little in the way of obligations either to protect that stability by promoting reasonable price continuity in tough times, or to refrain from exacerbating price volatility."[89] She proposed regulation that would require high-frequency traders to stay active in volatile markets.[90] A later SEC chair Mary Jo White pushed back against claims that high-frequency traders have an inherent benefit in the markets.[91] SEC associate director Gregg Berman suggested that the current debate over HFT lacks perspective. In an April 2014 speech, Berman argued: "It's much more than just the automation of quotes and cancels, in spite of the seemingly exclusive fixation on this topic by much of the media and various outspoken market pundits. (...) I worry that it may be too narrowly focused and myopic."[92] The Chicago Federal Reserve letter of October 2012, titled "How to keep markets safe in an era of high-speed trading", reports on the results of a survey of several dozen financial industry professionals including traders, brokers, and exchanges.[16] It found that risk controls were poorer in high-frequency trading, because of competitive time pressure to execute trades without the more extensive safety checks normally used in slower trades. "some firms do not have stringent processes for the development, testing, and deployment of code used in their trading algorithms." "out-of control algorithms were more common than anticipated prior to the study and that there were no clear patterns as to their cause." The CFA Institute, a global association of investment professionals, advocated for reforms regarding high-frequency trading,[93] including: Promoting robust internal risk management procedures and controls over the algorithms and strategies employed by HFT firms. Trading venues should disclose their fee structure to all market participants. Regulators should address market manipulation and other threats to the integrity of markets, regardless of the underlying mechanism, and not try to intervene in the trading process or to restrict certain types of trading activities. Flash trading Edit Exchanges offered a type of order called a "Flash" order (on NASDAQ, it was called "Bolt" on the Bats stock exchange) that allowed an order to lock the market (post at the same price as an order on the other side of the book[clarification needed]) for a small amount of time (5 milliseconds). This order type was available to all participants but since HFT's adapted to the changes in market structure more quickly than others, they were able to use it to "jump the queue" and place their orders before other order types were allowed to trade at the given price. Currently, the majority of exchanges do not offer flash trading, or have discontinued it. By March 2011, the NASDAQ, BATS, and Direct Edge exchanges had all ceased offering its Competition for Price Improvement functionality (widely referred to as "flash technology/trading").[94][95] Insider trading Edit On September 24, 2013, the Federal Reserve revealed that some traders are under investigation for possible news leak and insider trading. An anti-HFT firm called NANEX claimed that right after the Federal Reserve announced its newest decision, trades were registered in the Chicago futures market within two milliseconds. However, the news was released to the public in Washington D.C. at exactly 2:00 pm calibrated by atomic clock,[96] and takes 3.19 milliseconds to reach Chicago at the speed of light in straight line and ca. 7 milliseconds in practice.[97] Most of the conspiracy revolved around using inappropriate time stamps using times from the SIP (consolidated quote that is necessarily slow) and the amount of "jitter" that can happen when looking at such granular timings.[98] Violations and fines Advanced trading platforms Edit Advanced computerized trading platforms and market gateways are becoming standard tools of most types of traders, including high-frequency traders. Broker-dealers now compete on routing order flow directly, in the fastest and most efficient manner, to the line handler where it undergoes a strict set of risk filters before hitting the execution venue(s). Ultra-low latency direct market access (ULLDMA) is a hot topic amongst brokers and technology vendors such as Goldman Sachs, Credit Suisse, and UBS.[118][119][120] Typically, ULLDMA systems can currently handle high amounts of volume and boast round-trip order execution speeds (from hitting "transmit order" to receiving an acknowledgment) of 10 milliseconds or less. Such performance is achieved with the use of hardware acceleration or even full-hardware processing of incoming market data, in association with high-speed communication protocols, such as 10 Gigabit Ethernet or PCI Express. More specifically, some companies provide full-hardware appliances based on FPGA technology to obtain sub-microsecond end-to-end market data processing. Buy side traders made efforts to curb predatory HFT strategies. Brad Katsuyama, co-founder of the IEX, led a team that implemented THOR, a securities order-management system that splits large orders into smaller sub-orders that arrive at the same time to all the exchanges through the use of intentional delays. This largely prevents information leakage in the propagation of orders that high-speed traders can take advantage of.[121] In 2016, after having with Intercontinental Exchange Inc. and others failed to prevent SEC approval of IEX's launch and having failed to sue as it had threatened to do over the SEC approval, Nasdaq launched a "speed bump" product of its own to compete with IEX. According to Nasdaq CEO Robert Greifeld "the regulator shouldn't have approved IEX without changing the rules that required quotes to be immediately visible". The IEX speed bump—or trading slowdown—is 350 microseconds, which the SEC ruled was within the "immediately visible" parameter. The slowdown promises to impede HST ability "often [to] cancel dozens of orders for every trade they make".[122] Outside of US equities, several notable spot foreign exchange (FX) trading platforms—including ParFX,[123] EBS Market,[124] and Thomson Reuters Matching[125]—have implemented their own "speed bumps" to curb or otherwise limit HFT activity. Unlike the IEX fixed length delay that retains the temporal ordering of messages as they are received by the platform, the spot FX platforms' speed bumps reorder messages so the first message received is not necessarily that processed for matching first. In short, the spot FX platforms' speed bumps seek to reduce the benefit of a participant being faster than others, as has been described in various academic papers.[126][127]