Business

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.

Benefits

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.

Costs

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



Don’t go chasing waterfalls…find them on these drives!

BRISBANE isn’t all bright lights and city slickers.

Science Festival seriously awesome

Don't miss the World Science Festival Brisbane!

CALLING everyone who wants to see something totally cool.

Drink where the cool kids do this summer

There are a bunch of new bars open in Brisbane, make sure you're there!

CHECK out these new funky bars.

Discover Brisbane’s laneway gems

Brisbane's laneways will surprise you.

NOT all of Brisbane City is as it seems…

Top five things to experience this summer in Brisbane

Tangalooma is amazing if you're keen for a dive, kayak or swim.

THIS summer get out and explore your capital city.

Your boots are made for walking these tours

Brisbane Greeters tours are a great way to learn the local history of the city.

YOU don’t need a bike or bus for a seriously good tour of Brisbane.

Is Brisbane the new arts and culture capital?

Check out GOMA's latest exhibition - it's all about hair! GOMA 10 Ambassador Patience Hodgson visits Nervescape V 2016 by Icelandic artist Hrafnhildur Arnardóttir (aka Shoplifter), commissioned for ‘Sugar Spin: you, me, art and everything’ at the Gallery of Modern Art, Brisbane. 
Photograph: Natasha Harth, QAGOMA

THE rest of the world should be envious of this line-up!

No rain in sight and the struggle is here now

NO RAIN: Moore Park Cane grower Nick Glass is struggling to grow a decent crop in the hot dry weather.

Records may break this month but not the ones you would hope for

Want free stuff from Aldi? Here's how

Aldi is looking for product samplers.

FINALLY, the wait is over.

Local Partners

Bliss N Eso announce tribute show for stuntman

AUSSIE hip hop outfit Bliss N Eso have announced they will play a tribute show for the stuntman killed during the filming of their music video.

MOVIE REVIEW: Trainspotting sequel as good as original

Ewen Bremner in a scene from the movie T2: Trainspotting.

Director Danny Boyle proves sequels can be done well.

How Karl Stefanovic's wife, kids found out about girlfriend

Karl Stefanovic and Jasmine Yarbrough after their day on Sydney Harbour. Picture: Jonathan Ng

Pictures splashed across tabloid were shock to family

WATCH: Toowoomba opera hopeful's incredible voice

Kaitlyn Orange attends Opera Queensland auditions at Empire Theatres for Opera at Jimbour, Saturday, February 18, 2017.

Opera hopefuls vie for parts in performance at Jimbour House

MKR turns spiteful in suddendeath elimination

Alyse and Matt battled Josh and Amy in a spiteful elimination cook-off.

Bottom of the ladder faces off in spiteful sudden-death cook-off.

Jilted Married At First Sight groom rejected again

Is Married at First Sight groom's second chance over already?

Sir Elton John coming to Mackay: What you need to know

Sir Elton will come to Mackay and Cairns in September.

Tickets to the concert go on sale on March 14

Submarine, buses and 3000 tyres removed in $100K clean up

The list of things removed from this property is beyond astonishing

Popular island resort sells to loaded international investor

OUR PICK: Chris Foey's colourful shot of one of Gladstone's great tourism hot spots, Heron Island.

International investor snaps up piece of Gladstone paradise.

Expert: Why renters, home buyers may struggle

Matusik Property Insights director Michael Matusik.

What's next for the city's housing market

Massive seaside development of 3200 lots

DESIRABLE LIFESTYLE: The masterplan for the proposed Elliott Heads Estate.

"There's nothing else left along the coastline of Queensland now"

Ready to SELL your property?

Post Your Ad Here!