Emerging Markets-Are-Breaking-Down-In-2014 And Answer The Following Questions High Frequency Trading Explained

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High Frequency Trading Explained

Proponents argue that High Frequency Traders provide needed liquidity while opponents raise the flag of the “little guy” aka the small lot investor or retail trader, as being harmed by HFTs. The question is whether the average investor is truly a victim of HFT activity when most investors buy mutual funds, in addition the largest mutual funds do not use the exchanges for their large lot orders and are therefore rarely impacted by intraday HFT trading on the exchanges.

The question of whether High Frequency Trading is good or bad for the financial markets is not as simple as the news would have everyone believe. The problem and any solutions are as complex as the world of HFTs, which trade across all financial markets around the world.

The roots of High Frequency Trading came from the Day Trading Floor Traders of the 80’s and 90’s. The market makers of that era decided to try squeezing out the growing nuisance of rogue floor traders, who broke away from their prior employers on the exchanges to trade independently with the brand new PC computer that allowed them to trade at home. These independent day traders ushered in a new era of quick in and out trades, that took advantage of the wide spreads between the ask and the bid of the fractions pricing structure of that day.

Market makers lobbied for decimal pricing structure believing that a tighter bid and ask would squeeze out the professional independent day trader and the newly minted retail day trader. These traders could see the huge lot orders of the institutional clients moving through exchanges, and would jump in ahead of the huge lot order forcing price up. This infuriated the institutions and the market makers who managed those large lot orders on behalf of the giant mutual and pension funds.

Decimal pricing replaced fractions in 2002 and did for a short period of time reduce the day trading activity, however this was only a short reprieve.

By 2005 computers had evolved to provide much faster speeds, and more sophisticated software provided algorithms and formulas that could track orders moving through the system. Without the large spreads, day trader professionals turned to faster speeds. Faster speeds meant that they could trade more frequently with even a penny or half penny spread and still make profits.

HFTs quickly caught on and the huge liquidity that these firms provided became a highly lucrative opportunity for exchanges, that had seen a steady loss of revenues as more of the smaller exchanges emerged along with more ECNs. The Dark Pools also started taking more and more of the order flow away from the exchanges. Dark Pools were a direct result of HFT trading on exchanges. Now instead of the large lot orders moving through the exchanges, large lots were being filled in Dark Pools. This caused the exchanges to lose more money.

Then also exchanges went public and as public companies, their goals and business structured changed dramatically. The NYSE and NASDAQ needed to make their shareholders happy instead of simply providing an excellent exchange trading experience for their clients. They sought out more HFTs to fill the void caused by the loss of the large lot investors, who no longer used the exchanges for their millions of shares of orders. HFT activity increased as exchanges offered these firms maker-taker rebates to provide liquidity for the exchanges.

HFT activity peaked in 2009, with an SEC confirmed 56% dominance of all orders on the stock market at that time. It has been stated in several internet sites that it was as high as 77%, but that was ALL automated orders and not just HFT order flow.

Because the HFTs offered liquidity and could trade anywhere, exchanges offered a maker-taker contract with many of the HFT firms. A maker-taker acts at times like a market maker, however the maker-taker is not required to “make a market” as a market maker is obligated by regulation and law.

A maker-taker is a rebate program designed by exchanges that pays a rebate back to the HFT whenever they provide liquidity to the exchanges. The exchanges needed the HFTs to provide liquidity because there was an unexpected negative side effect to changing from fractions to decimals.

With the tighter spreads, more and more market makers discovered they could not make sufficient profits and compete with high-speed computers. Slowly market makers on the NYSE floor disappeared leaving only a few from what had once been a busy, crowded trading floor. Across the US in every exchange and every financial market, market makers began disappearing.

The exchanges lost more liquidity as HFT dominance in the stock market rose between 2005-2009, driving giant lot institutions to Dark Pool venues known as Alternative Trading Systems ATS.

The decimals that everyone believed would make the markets more efficient had resulted in less efficient markets, a huge need for maker-takers to fill the role of the declining market makers and the ever increasing speed of transactions.

Now the argument about how to regulate and control the HFTs is gaining political popularity and once again, the financial markets face a crossroads moment. Any change to how the financial markets operate from something that seemed as simple as changing from fractions to decimals, does create reverberating impacts that can’t be foreseen, projected, or even comprehended at the time.

No one in 2002 thought that decimals would give rise to a new form of high frequency day trading. No exchange in 2005 really understood how HFTs would alter not just intraday activity, but the overall volatility of the markets. No one could predict the demise of market makers who had been an anchor for the market that held it steady, stable, and strong for decades.

Solutions that have been presented are lacking in a thorough understanding and comprehension of how a small change can have massive repercussions for not only the stock market, exchanges, ATS, and every market participant but for every other financial market globally as well.

HFTs do need to be regulated but their true roles, benefits, problems, risks, and areas open to fraud must first be identified. So far none of these have been empirically documented by anyone.

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