Making sense of high-frequency trading

AS THE sixth iteration of The Fast and the Furious franchise rolls out in cinemas, a greater speed demon lurks in our financial markets: high-frequency traders (HFTs).

While the good guys in Fast 6 are clear cut, academic researchers remain undecided on whether HFTs are heroes or villains of the market.

The fact that HFTs can even be deemed heroes may appear outrageous to the casual observer given the media regularly portrays them as villains.

Even some exchanges and market regulators have made up their mind on HFTs or are proposing ways to curb their activity. So what has academic research found so far?

What is high-frequency trading?

High-frequency trading is a nebulous phrase, though it is considered a subset of algorithmic trading (AT), which is the use of computer programs to trade on electronic exchanges.

High-frequency traders take algorithmic trading to the extreme and quickly trade in and out of financial instruments, sometimes only holding stock for a fraction of a second. Their profitability depends crucially upon both their speed in processing information and speed in trading, measured in milliseconds. Such behaviour led high-frequency trading to be branded as digital age pickpockets, as their pursuit of fast profits appears to allow them to get in and out of the market before others can click the buy or sell button.


Indirect evidence of the benefits of high-frequency trading is shown in studies on algorithmic trading, published in The Journal of Finance and forthcoming in Journal of Financial and Quantitative Analysis.

These studies find that more algorithmic trading allows buyers and sellers to trade at more efficient prices. While the findings are on the broad algorithmic trading group, high-frequency traders appear to make up the majority of that group, with estimates at 73% for US trading.


Several papers however, argue that there are significant costs. For example, competition by HFTs may make markets worse, argues another paper also published in The Journal of Finance. They show that financial expertise improves a firms' ability to estimate value when trading a security.

Such financial expertise creates an unbalanced possession of information among the market participants, which, under normal circumstances, works to the advantage of the expert. This advantage is neutralised in equilibrium, however, by offsetting investments by competitors. Moreover, when market volatility increases, a market participant with expertise could take advantage of information superiority. This triggers breakdowns in liquidity, destroying gains to trade and thus the benefits that firms hope to gain through higher levels of expertise.

Even in well-functioning markets, HFTs may play a dysfunctional role, as modelled in a paper published in International Journal of Theoretical and Applied Finance. According to the paper, HFTs can create a mispricing that they unknowingly exploit to the disadvantage of ordinary investors. This contrasts with other participants who make financial markets more efficient by taking advantage of and thereby eliminating mispricing. This mispricing could be generated by the collective and independent actions of HFTs, coordinated via the observation of a common signal.

Neutral views

A couple of working papers provide differing neutral views on HFTs. Researchers at the University of Illinois argue that HFTs have no observed social benefit. They find that an arms race in speed at the sub-millisecond level is a positional game in which a trader's pay-off depends on her need for speed relative to other traders. However when HFTs profit due to speed advantages over other traders, the profit is offset by the technological costs required to gain such speeds.

Using detailed transactions data of four UK stocks that identifies trading participants including individual HFTs, researchers from the Bank of England find that HFTs may be good or bad depending on their trading strategy. They find that while some HFTs mostly consume liquidity and therefore are potentially disruptive, others mostly supply liquidity and therefore assist markets.

Researchers have just started delving into the world of HFTs. Ultimately the weight of such research will impact on the stance of exchange operators and market regulators and their decisions to throttle HFTs. While movie goers await the inevitable next iteration of The Fast and the Furious, high-frequency traders are anticipating their next instalment.

Topics:  fast and the furious stock markets the conversation

Men's Shed to open soon

MEN'S SHED: Rob Miller and Col Driver at the new Gayndah Men's Shed.

The Gayndah Men's Shed is ready to open

Witnesses claim couple were 'thrown' from car after crash

Ambulance generic

The crash happened about 2pm with no injuries reported

Woman taken to hospital after crash

Woman taken to hospital in stable condition

Local Partners

Get help at financial info day

A FREE information day to help anyone in need of financial help or advice is being held today as part of Anti-Poverty Week.

Men's Shed to open soon

MEN'S SHED: Rob Miller and Col Driver at the new Gayndah Men's Shed.

The Gayndah Men's Shed is ready to open

Former Split Enz front man Tim Finn finds new niche

Singer Tim Finn has written the music for theatre production Ladies in Black.

Musician finds his way to theatre

Workshops to show you how to bring puppets to life

STRING SECTION: Two puppet-making workshops will be held in the region.

Ever wanted to know how to make puppets?

Azealia Banks won't take legal action against Russell Crowe

Rapper Azealia Banks

Rapper drops legal action against Russell Crowe

Brad Pitt meets with his kids amid divorce proceedings

Actor Brad Pitt

Brad Pitt has met up with his oldest son Maddox

Pictures of Taylor Swift allegedly being groped are sealed

They could "complicate jury selection".

Bruce Springsteen finds therapy useful

Singer Bruce Springsteen

Singer encourages others to seek help

Kerry Washington wants one more child

Kerry Washington recently gave birth to her second child

Kerry has only just become a new mum again

TRAVEL: Musicals light up Sydney

David Campbell performs in Dream Lover.

We take a trip through one of Sydney's finer scenes

Hit songwriter's Noosa mansion on market

SPECIAL PLACE: The Cintamani estate is going to tender, marketed by Tom Offermann Real Estate.

Is this Queensland's best property?

Kiwi siblings snap up Dotcom mansion for $32.5m

The new toy company owners of the Coatesville mansion want replace any controversy with positivity and fun. Photo / Barfoot and Thompson

The trio paid $32.5 million for the property in June

New $200 million development will create 580 jobs

Cassie And Josh with baby Alfie and daughter Andee. They have bought at new Lennox Head development Epiq.

Majority of new positions will be given to Northern Rivers locals

Cherrabah's mega resort plans axed

PLANS for a massive development at Cherrabah have been scrapped.

What our mayor thinks of the new draft SEQPlan

The plan to use the innovative technology as part of the new Maroochydore CBD was cemented on site today when Mayor Mark Jamieson and Envac Asia Region president Chun Yong Ha formally signed the contract for the $20 million underground waste collection system.

New plan accommodates Sunshine Coast Council's vision for growth.

Dusit Thani finance crisis 'just a small hiccup'

ON TRACK: Springfield Land Chairman, Maha Sinnathamby, Ipswich Mayor Paul Pisasale, Developer Richard Turner and Springfield Land Deputy Chairman, Bob Sharpless, at the recent resort sod turning ceremony.

Property developer says project remains firmly on track