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‘People no longer are responsible for what happens in the market, because computers make all the decisions,’ – Michael Lewis, author of Flash Boys.
More than half of all equities traded in the US is done not by humans but by super computers capable of placing millions of orders each day and gaining advantage through moving milliseconds before the competition. This high-frequency trading has seen market makers and the largest players use algorithms and data to make money from placing vast amounts of orders to earn wafer thin margins.
But these margins have become even slimmer and the opportunity has dwindled: revenue last year was around 86% lower than it was when high-frequency trading was at its peak less than a decade ago. With pressure continuing to grow consolidation has started to take hold of the sector as high-frequency traders look to fend off tougher conditions.
We have a look at what high-frequency trading is and why it has declined.
What is high-frequency trading?
It comes to down harnessing the power of technology to gain advantages whilst trading. High-frequency trading sees large organisations such as investment banks and hedge funds use automated trading platforms that, using algorithms, are able to track numerous financial markets and execute vast amounts of orders.
Learn more about algorithmic trading and how it works
If programmed correctly, high-frequency trading offers an obvious advantage to those institutions that have access. The highly powerful computers can spot new trends across global financial markets and act automatically before the rest of the market has had a chance to even identify the trend, let alone trade it.
Read more about automated trading and how it works
The generally accepted characteristics of high-frequency trading and the firms that do it are:
- Deals in extremely high number of deals
- Orders are rapidly cancelled
- Holds positions for very short periods of time
- Holds no positions at the end of each trading day
- Earns wafer thin margins per trade
- Use of data feeds and proximity services
- Proprietary trading (when a bank etc. invests for its own gain rather than on behalf of clients)
Why does high-frequency trading exist?
High-frequency trading allows large institutions to gain a small but notable advantage in return for providing vast amounts of liquidity into markets. The millions of orders that can be placed by high-frequency trading systems means those using them are lubricating the market and, in return, they are able to increase profits on their advantageous trades and obtain more favourable spreads.
The nature of high-frequency trading satisfies both sides. Institutions can gain an advantage but one that is based on volume. The returns per transaction are tiny and therefore a huge number of trades must be completed to truly benefit which, in turn, ensures enough liquidity is being pumped into the markets. Firms have two direct income streams: one from earning the spread for supplying liquidity and another through the discounted transaction fees that trading venues provide to make their markets more attractive to high-frequency traders.
High-frequency trading: spreads and liquidity
Spreads and liquidity go hand-in-hand. Markets with high activity levels offer smaller spreads while those with lower trading volumes tend to offer larger spreads: with the spread being the difference in price between the buy (offer) and sell (bid) prices quoted for an asset.
The foreign exchange market, for example, sees over $5 trillion of currency traded each and every day to hold the title as the most liquid market in the world and it is this staggering volume that creates small spreads that only offer material profit opportunities if they are traded in large volumes. It is this reason why many choose to use leverage in markets with high liquidity such as forex, so volumes are maximised in order to take more substantial positions that otherwise might not be worthwhile. For less liquid markets such as small-cap stocks the spreads on offer are typically much larger.
Is high-frequency trading ethical?
Giving large institutions an advantage over smaller organisations and retail investors raises obvious questions about the ethics and fairness of high-frequency trading, and rightly raises the argument that it doesn’t help promote a level playing field. As well as competing with one another retail investors have to compete with an algorithm that is far superior than human trading.
Some also argue that the liquidity provided by high-frequency traders – the service they provide in return for gaining the advantages – is not as effective as its supposed to be because the speed at which high-frequency trading operates can see money flow in and out of a market within a blink of an eye, preventing other investors from benefiting from it.