HIGH FREQUENCY TRADING, TECHNOLOGY, AND THE INDIVIDUAL

INVESTOR/TRADER

Introduction and History

Markets of all kinds have existed for centuries. Markets have always faced problems as changes

in market structure unnerve market participants as information sways from one to another. Technology

has been changing markets since the beginning.

In 2001, United States markets experienced a major change when it was announced that equity

markets would now trade in decimals instead of 1/16ths. The goal at the time was to reduce spreads

across the markets to lower the cost to all investors and particularly individual investors.

The result was a massive change in market mechanics. The intermediaries were effectively priced

out of their market making activities. This was the beginning of a mass exodus from floor trading to

computerized trading.

The nature of computerized-anything creates new efficiencies. The new efficiencies attracted an

entirely new set of investors and traders. Many were individuals that wanted to trade but found

transaction costs a barrier-to-entry. The advent of computerized trading also attracted high frequency

traders and their algorithms, black boxes, and cutting-edge trading strategies that have improved market

efficiency, reduced costs, and provided an increased level of liquidity.

What Is High Frequency Trading?

High frequency trading is one of the most significant market structure developments in

recent years.1 High frequency trading is a technology – not a strategy. High frequency trading is

simply a new means, or tool, used to implement traditional trading strategies such as arbitrage

1 Securities Exchange Act Release No. 34-61358, 75 FR 3594, 3606 (January 21, 2010) (“Concept Release”).

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and market-making.2 There many different definitions of high frequency trading depending on

the market participant you are asking. Generally, high frequency trading is a large part of overall

algorithmic trading and computer-aided trading.

There is no precise legal definition in the United States. In 2010, the United States Securities

& Exchange Commission (“SEC”) offered general parameters leaving much of market activity

subject to interpretation.

1. Proprietary trading firm (which may or may not be a registered broker-dealer and a

member of FINRA), proprietary trading desk of a multi-service broker-dealer, or a hedge

fund3;

2. Use of co-location services (server as close to exchange as possible)and individual data

feeds offered by exchanges and others to minimize network and other latencies4;

3. Very short time-frames for establishing and liquidating positions5;

4. Submission of numerous orders that are cancelled shortly after submission6;

5. Ending the trading day in as close to a flat position as possible7.

The SEC is not suggesting that every element must be satisfied for high frequency trading to

be present in the markets. The SEC is at a disadvantage because they cannot gain access to

individual account data. So, the SEC must use general proxies of accounts using market-data.8

What Types of High Frequency Trading Strategies Are Being Utilized?

2 European Principal Traders Association, Petition on Revised Proposals for Markets in Financial Instruments Directive (MiFid II) p. 23 Securities Exchange Act Release No. 34-61358, 75 FR 3594, 3606 (January 21, 2010) (“Concept Release”).4 Id.5 Id.6 Id.7 Id.8 Id.

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The SEC has identified four different types of high frequency trading strategies:

1. Passive Market Making: is the submission of non-marketable resting orders that provide

liquidity to the marketplace at specified prices.9 Non-marketable resting orders are orders

sent to the exchange that ‘rest’ in the market depth indicator without the intent to be

executed but with the intent to provide market liquidity. High frequency trading uses this

strategy. Since the orders are resting, they need to be updated frequently in response to

market conditions.10

2. Arbitrage: is trying to profit from price differentials existing for seconds and maybe less.

High frequency trading is needed in this strategy to capture profit opportunities that exist

for only a moment;

3. Structural Strategies: exploit structural vulnerabilities using low latency market data.

Low latency is how much data the market participant is viewing compared to other

market participants. High frequency trading seeks to benefit from decreasing latency

arming the trader with more data.

4. Directional Strategies: can be split into two subcategories:

a. Order Anticipation Strategies: These strategies seek to profit by using high

frequency trading to anticipate institutional order flow and then ‘riding the wave’

by piggybacking orders.

b. Momentum Ignition Strategies: These strategies send large orders into the

marketplace with the intent to spur price movement up or down. The idea here is

high frequency trading can send more of these orders more quickly. The high

frequency trading firm then knows the true source of the change in price direction.

9 Id.10 Id.

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Within these strategies, a few statistics hold true across the high frequency trading

industry. For example, on a single trade, the win rate is between 52-53%. On all daily trades, the

win rate is 86%. And on a weekly basis, the win rate is nearly 99%.11 So it is critical that high

frequency traders execute many trades in a day for the law of large numbers to be effective. The

longer the time-frame and the more voluminous trading will allow high frequency trading firms

to maintain their razor-thin margins.

What Myths Surround High Frequency Trading?

As with most technological advances, people are skeptical of the change to their lives at the

outset. Some people fear what they don’t understand. E-Commerce suffered through skepticism

for a decade before it became the new way to buy and sell. This is especially true when the

technological change has anything to do with money.

So, what types of disinformation have been disseminated by the Wall Street propaganda

machine? The biggest misconception is thinking that high frequency trading somehow provides

an opportunity to know what orders are coming into the market.12 After determining what orders

will be coming in, it is said the high frequency trader will ‘front-run’ or ‘trade ahead’ of the

orders to profit at the expense of individual investors.

However, the only way high frequency trading could profit if this were true would be to

know the exact price and size of the order. This is impossible. So even if high frequency trading

had the capability to determine order size, which it doesn’t, not knowing the price would prevent

profitability.

11 U.S. Market Structure, Credit Suisse, May 20th, 2014, p. 3.12 2014 London Summit. Future of Trading. Milken Institute. October 2014.

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High frequency trading is not synonymous with ‘dark pools’. Dark pools were a

controversial issue in financial markets in the 2000’s.13 Dark pools are private markets hidden

from the ‘lit’ markets.14 Dark pools escaped most regulation that was present on the exchanges.

Although high frequency traders do trade in dark pools, they actually prefer to trade in the ‘lit’

markets.

Another misconception is that high frequency trading firms compete with long-term

investors. However, long term investors have neither the ability to identify high frequency

trading opportunities nor the interest. 15 Long-term investors are insulated from any potential

negative effects of high frequency trading because long-term investors are in the markets for

completely different reasons.

Mike Gitlin, the former Head of Global Trading for T. Rowe Price made exactly this point

when he wrote to the SEC in 2010: “It is simply not economically feasible to suggest that an

individual investor must have equal trading technology and capabilities as that of an investment

manager with billions of client dollars under management… It is not clear to us that a smaller

institution or individual investor would benefit from such tools to execute their orders.16

High frequency trading firms compete with each other. High frequency trading firms vary in

their ability to predict non-high frequency order flow.17They do not compete with everyday

investors and traders. The democratization of technology has leveled the playing field.18

13 Scott Patterson. Dark Pools. 2013.14 Id.15 SEC Comment Letter submitted by TradeWorx, April 21, 2010 p.4.16 Kovac, Peter (2014-10-29). Flash Boys: Not So Fast: An Insider's Perspective on High-Frequency Trading (Kindle Locations 648-653). Directissima Press. Kindle Edition.17 Equity Market Structure Literature Review, Part II, High Frequency Trading, Staff of the Division of Trading and Markets, Securities & Exchange Commission, March 18th, 2014, p. 31.18 U.S. Market Structure, Credit Suisse, May 20th, 2014, p. 3.

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The competition between high frequency trading firms is gradually succumbing to the law

of diminishing returns. As more firms enter the space, the inefficiencies decrease and the profit

from existing inefficiencies decrease. The consequence is that not all high frequency trading

firms are profitable. And when they are profitable, the entire industry barely makes a dent in

financial services with approximately one billion in profits in in 2012 – down from five billion in

2009.19

Many people on Wall Street – especially the media with their scare tactics – also believe that

high frequency trading is a kind of bubble that can burst. 20 The reality is that most high

frequency trading firms cannot put up a significant amount of capital and do not use material

leverage.21 Rather, bubbles are caused by long-term investors who succumb to the herd mentality

of markets.22

Some professionals and pundits also claim that high frequency trading adds no value to the

real economy. This misconception is easily rebuffed. High frequency trading has substantially

reduced frictional costs in the markets.23

Many professionals and pundits believe that high frequency trading poses systemic risk

issues and contagion effects.24 This is not true as most high frequency trading firms end the

intraday session flat. In fact, high frequency trading firms do not pose systemic risks due to

19 Matthew Philips. What Michael Lewis Gets Wrong About High Frequency Trading. April, 2014. http://www.businessweek.com/articles/2014-04-01/what-michael-lewis-gets-wrong-about-high-frequency-trading

20 SEC Comment Letter submitted by TradeWorx, April 21, 2010 p.4.21 Id.22 Id. 23 European Principal Traders Association, Petition on Revised Proposals for Markets in Financial Instruments Directive (MiFid II) p. 9.24 See id. at 10.

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‘overcrowding’ a particular side of the markets because only the fastest high frequency trading

firms will be able to profit leaving many other high frequency trading firms with losses.25

Another common misconception is that high frequency trading somehow caused the May 6,

2010 Flash Crash in the United States equity markets. A 2010 SEC and Commodity Futures

Trading Commission (CFTC) report prepared for Joint Advisory Committee on Emerging

Regulatory Issues found that high frequency trading was not the cause of the Flash Crash. In fact,

high frequency trading firms were net buyers during the beginning of the Flash Crash.26

Notwithstanding the findings, many alarmists on Wall Street still claim that high frequency

trading caused the Flash Crash. It simply isn’t true.

Many also claim that high frequency trading increases volatility. However, a strong majority

of the academic research finds that high frequency trading has no effect or decreases volatility.27

Finally, some (usually market participants that used to get a free ride) claim that high

frequency trading provides only ‘fake liquidity’.28 This argument assumes that high frequency

traders have no value-at-risk. The bottom is that every order posted by high frequency trading

firms can be executed against – threatening the high frequency trading firms strategy.

What Are The Benefits Of High Frequency Trading?

The positive relationship between speed, liquidity, and spreads is well documented and

supported by empirical evidence. 29 “High-frequency traders, specifically electronic market-

makers, by competing with a fair set of rules, have dramatically reduced the cost of trading over 25 Id.26 Report of The Staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, Findings Regarding The Market Events of May 6, 2010, p. 14.27 European Principal Traders Association, Petition on Revised Proposals for Markets in Financial Instruments Directive (MiFid II) p. 928 See id at 10.29 See id. at 7.

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the past decade, by five times or more. TD Ameritrade, the largest online retail broker, estimates

that in the last ten years transaction costs have declined 80% for retail investors; Vanguard, the

largest U.S. mutual fund manager, estimated that they now save $ 1 on every $ 100 of stock

bought and sold. In short, everyone – retail investors, mutual funds, pension funds, whoever –

has benefited significantly.”30

First, the speed involved in high frequency trading should not be feared. Speed is simply an

evolution of markets over time. For example, the benefit of technology was integrated as early as

1903 at the New York Stock Exchange with the introduction of the pneumatic tube system.31

Speed fuels the reduction of spreads, improved price discovery, reduced volatility, and

liquidity.32 High frequency trading firms can trade in time-frames as small as milliseconds. The

lightning speed of these transactions reduce spreads by updating the current price data so that

securities can be traded with the smallest bid-ask spread as possible. This reduces costs as

investors and traders no longer have to pay an intermediary a significant spread.

This decrease in spreads results in improved price discovery. Investors and traders no longer

have to worry about significant issues relating to getting the best price. When this occurs the

prices that investors and traders receive are a more accurate representation of price at the time of

transaction.

30 Kovac, Peter (2014-10-29). Flash Boys: Not So Fast: An Insider's Perspective on High-Frequency Trading (Kindle Locations 95-, 101). Directissima Press. Kindle Edition.

31 High-Frequency Trading – A Discussion of Relevant Issues, Eurex Xetra Deutsche Borse Group, London May, 2013, p. 5.32 Equity Market Structure Literature Review, Part II, High Frequency Trading, Staff of the Division of Trading and Markets, Securities & Exchange Commission, March 18th, 2014, p.23.

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The improvement in price discovery leads directly to reductions in volatility. Since prices

are reflected more accurately, investors and traders can have more confidence in their quoted

orders. And volatility decreases as investor confidence increases.

High frequency trading also assists in market price synchronization. Market synchronization

tries to ensure that the values of all related securities change contemporaneously.33 Market

synchronization is critical to avoid inefficiencies. A November 2013 study at The University of

Oxford used empirical data to prove that high frequency trading synchronizes markets.34 And in

2010 the CME Group launched a study to see if high frequency trading improved liquidity. The

study concluded that high frequency trading ‘enhanced liquidity and reduced volatility.35

The following chart depicts how high frequency trading provides liquidity in extreme market

situations. The blue and orange price levels are high frequency trading firms trading against each

other. The spikes in the red and green price levels are attributed to non-high frequency trading.

As you can see, as the non-high frequency trading becomes more volatile, the high frequency

trading remains relatively stable. This stable flow of orders provides liquidity for the rest of the

market to lean on.36

33 Austin Gerig. High Frequency Trading Synchronizes Prices in Financial Markets. University of Oxford. November, 2013.34 Id.35 CME Group. Algorithmic Trading and Market Dynamics. July 15, 2010.36 Eurex Exchange HFT Research: A Three Dimensional Representation of HFT Activity. http://www.eurexchange.com/static/dav/Screencasts/HFT/02_A_three_dimensional_representation_of_HFT_activity/02_A_three_dimensional_representation_of_HFT_activity.htm

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Are Their Safeguards To Protect Individuals from High Frequency Trading?

The broadest goal for safeguards is to prevent high frequency trading and other algorithms

from losing control causing a serious market failure.37 Some of the safeguards that protect against

serious market failure include: implementing procedures to mitigate risk across all parties

involved in a securities transaction, plausibility checks using a ‘reasonableness’ test on entered

orders, network architecture throttle that limits the maximum through put per second, and a

‘stop’ button used by clearing firms to halt market participants activity. 38 These types of

37 High-Frequency Trading – A Discussion of Relevant Issues, Eurex Xetra Deutsche Borse Group, London May, 2013, p. 46.

38 See id. at 47-52.

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safeguards provide additional market protection in the event the strong evidence supporting high

frequency trading turns out to be weaker.

Have United States’ Courts Encountered High Frequency Trading?

As with any change in society, the enacted laws at the time need to be reevaluated. This is

especially true in such a far-reaching industry as the securities industry. The courts have just

recently begun to opine on cases where high frequency trading posed issues to the integrity of the

capital markets. In September 2014, a Special Grand Jury for the United States District Court for

the Northern District of Illinois Eastern division indicted Michael Coscia, a trader using high

frequency technology to profit from ‘spoofing’.

The Special Grand Jury alleged six counts of commodities fraud and seven counts of

spoofing. Spoofing is a method of abusing high frequency trading. The essence of the scheme is

to manipulate the price of a security or commodity before the violating party actually trades the

same security or commodity. The high frequency trader manipulates the current best bid or best

offer with an out-of-the money trade that is never intended to be executed.

In order for this scheme to work, the trader must use speedy high frequency technology.

Otherwise, the trader risks getting his out-of-the-money order filled, which would destroy the

entire scheme. The trader also sends a resting order, which he will ultimately profit from the

manipulation of the current best bid or best offer when out-of-the money order is immediately

canceled. To highlight the necessity of high frequency trading under this scheme, a brief example

is needed.

1. Trader sees the current bid at $20 and the current ask at $22 that last traded at $21;

2. Trader places an order to sell 100,000 at $21.50;

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3. Trader simultaneously places an order to buy 10 at $20.50;

4. The market sees the large sell order and anticipates a decline in price. So another trader is

more than willing to fill your buy order for 10 at $20.50.;

5. After the trader’s buy order is filled, the trader uses high frequency trading speeds to

cancel the 100,000 sell order at $21.50;

6. Trader now has no orders outstanding and now owns 10 at $20.50;

7. Trader then submits a buy order for 100,000 at $20.50 and another resting order to sell

his 10 at $21;

8. The market sees the large buy order and anticipates an increase in price. So another trader

is more than willing to fill your sell order for 10 at $21;

9. A few milliseconds pass and the trader uses high frequency trading speed to cancel the

large buy order;

10. Trader now has no orders outstanding and now owns nothing but is left with a

manufactured $0.50 per share profit. At only 10 shares, this is only $5. However, the

numbers increase exponentially as the share size increases.

In this case, Michael Coscia performed this scheme over and over in futures contracts for

soybean oil, Pound FX currency futures, high-grade copper futures, Euro FX currency futures,

gold futures, soybean meal futures. Needless to say, the size of the scheme and its ability to be

performed in any market caught the attention of domestic and international regulators. Michael

Coscia’s Panther Energy Trading, LLC settled with the United Kingdom Financial Conduct

Authority for approximately $900,000 and the Commodity Futures Trading Commission for

approximately $2.8 million.39

39 Matt Levine, Prosecutors Catch a Spoofing Panther, http://www.bloombergview.com/articles/2014-10-02/prosecutors-catch-a-spoofing-panther

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So the courts have been used on the cutting-edge topic of high frequency trading. As more

cases arise, there will inevitably be more indictments and schemes uncovered. So far the

regulations in place for market manipulation have worked.

ANALYSIS FOR FUTURE CONSIDERATIONS

Should High Frequency Trading Be Directly Regulated?

High frequency trading should not be directly related a regulatory body. As discussed above,

high frequency trading provides the benefits of reduced costs, increased liquidity, and price

synchronization. The benefits that high frequency trading bestow on markets are without

significant negative effects.

The fact that high frequency traders can profit in a different manner than other investors and

traders does not warrant regulation. High frequency traders do not compete with everyday

investors and traders. High frequency traders compete among themselves for the right to execute

orders – not to trade with everyday investors and traders.

Adding additional regulation to the financial markets decreases the chances for a free

market. Regulation should only be implemented if necessary for the protection of investors and

traders. Here, there is no need for protection – at least in the form of additional regulations.

Regulating high frequency trading will only serve to slow down market evolution. Today’s

markets must accept technology as an ally instead of threat to the orthodox way of doing things.

The sooner that market participants embrace technology, the sooner the markets can evolve with

an ever-changing financial landscape.

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The Wall Street Journal quoted Larry Tabb, founder and CEO of the research firm Tabb

Group, as he was about to testify before a Securities and Exchange Commission panel in October

2012: “The macro goal of these rules seems to be to slow down the markets, decrease

speculation and intermediation, reduce gaming and curtail short-term equity trading profitability,

but if these rules are enacted, I’m not sure that we will experience the perfect market that

regulators are hoping for.”40 Since there is no perfect market, regulators should stop trying to

create a perfect market.

Some have proposed aggressive tax treatment of short-term trades made by high frequency

traders. The idea is to use the tax code to serve a securities regulatory function. However, any

additional tax will make high frequency trading unprofitable. If it is unprofitable, then high

frequency trading will cease to exist taking with it all the benefits to financial markets.

Proponents of this idea would be wise to remember the purpose of the securities laws: to protect

the integrity of financial markets while allowing for capital formation. Again, there is no need

for protection from high frequency trading. So any tax would be an unnecessary tax that would

interfere with the evolution of market behavior.

If regulations do come down, regulators should make there interference with markets as

unremarkable as possible. One idea that would give market participants more confidence would

be if a license was required to be a high frequency trader similar to a broker being required to be

licensed. This is a simple way to allow the evolution of high frequency trading without

interrupting free market economics.

Should High Frequency Trading Firms Have Obligations To The Market?

40 On-Line Trading Academy. High Frequency Trading. http://www.tradingacademy.com/resources/financial-education-center/high-frequency-trading.aspx

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Although high frequency trading’s benefits far outweigh its costs, some argue that firms

should have obligations to the market, i.e. not turning off the algorithms when things look bad,

staying in the market to provide liquidity when there is not much liquidity available, etc. The

problem with those arguments is that they presuppose that high frequency trading is bad for

markets and thus should have obligations beyond being a market participant. Since high

frequency trading is actually good for markets, the idea that it should have additional obligations

is unfair.

Despite the lack of obligations, high frequency trading firms would be best served to

voluntarily take on obligations for the betterment of the market system. High frequency trading

firms will only be profitable if they exist. Committing to providing liquidity in volatile markets

will help ensure that the best firms will exist and will be profitable.

Do High Frequency Trading Firms Serve An Altruistic Role?

In fact, high frequency trading firms do serve an altruistic role in financial markets. These

firms have exposed the Wall Street machine showcasing just how bad individuals were being

ripped off. This increased exposure has served as a deterrent for future inequities between

institutions and individuals. In that light, there should be no disagreement about the benefits that

high frequency trading has provided individuals.

Is High Frequency Suitable For The Individual Investor/Trader?

High frequency trading is trading among sophisticated technological trading firms. Mom and

Pop investors and home-gamer traders should not participate or attempt to participate in such

complicated strategies. Individual Investors and traders should focus their attention on other

market analyses such as fundamental research and technical analysis. Individuals – even those

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that trade intraday – should not pay attention to what algorithms are doing. The algorithms have

no material effect on individuals. In the worst case scenario, a position opened by an individual

might be filled a few pennies or ticks off the national best bid or offer. However, the decision-

making process individuals go through should not be milliseconds. It simply doesn’t matter.

Do The Principles Of Supply and Demand Still Govern Markets With High Frequency

Trading?

Sam Seiden, professional trader and Chief Education, Products and Services at On-Line

Trading Academy argues that high frequency trading is governed by the overarching principles

of supply and demand.41 Securities are bought and sold just like anything else is bought and sold

in life. The securities markets are a financial grocery store with different products in different

aisles with different instructions and uses.

When supply exceeds demand, prices tend to decline. When demand exceeds supply, prices

tend to rise. Einstein said make things as simple as possible – and no simpler. Occam’s Razor

theorizes that in the presence of competing theories, the simplest explanation is usually the best

explanation.

Einstein and Occam would have been great investors or traders. Einstein and Occam would

not spend an extensive amount of time trying to work through the minutia of high frequency

trading studies. They would have made it simple. They understood the governing dynamics of

price and supply and demand.

So, despite all of their complexity, trading is still primarily governed by supply and

demand. High frequency trading is simply noise that should be ignored by individuals. With

41 On-Line Trading Academy. Lessons From The Pros. High Frequency Trading – Good or Bad? April 2014. http://lessons.tradingacademy.com/article/high-frequency-trading-good-or-bad/

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supply and demand still in control of market movements, high frequency trading becomes less of

an issue.

CONCLUSION

Financial markets should embrace technology. Financial markets should embrace technology now.

Financial markets must accept technology to continue the evolution of the financial markets.

High frequency trading should be applauded for the increases in overall market efficiencies that have

come about since the introduction of such trading. High frequency trading is just another excuse for the

Wall Street fashion show to introduce a difficult concept to confuse investors and traders. High frequency

trading should not be used a pretense to get individuals to throw their hands up in the air and give their

hard earned money to a financial institution for management.

High frequency trading will be one of the earliest technological advancements to significantly change

market mechanics. Undoubtedly, new technologies will also surface. And no matter how beneficial the

change, the change will be met with skepticism by institutions and individuals. Hopefully, now that they

have seen the positive effects of technology, they will be more willing to accept change for the integrity

and operation of the financial markets.

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