Here's What You Need To Worry About From High-Frequency Trading

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Ever since the meltdown at Knight Capital (NYSE: KCG  ) earlier this month, the debate over high-frequency trading has exploded.

In short form, high-frequency trading is a flavor of trading that leverages computers and the speed of super-fast data connections to make lightning-quick trades, and lots of them. This means that, often, the trader's servers are situated in the same data center as the exchange's servers. While there's no single strategy of a high-frequency trader -- they might be acting like a market maker, or playing index arbitrageur -- the common thread is that they all rely on speed to succeed.

So, the $1 trillion question (inflation is brutal) is: Is this type of trading a major risk for markets, or closer to a non-factor?

Earlier this month, an animated graphic made rounds that many commentators pointed to as clearly showing that high-frequency trading is in the process of blowing up markets. I countered that the graphic showed the growing presence of high-frequency trading, but didn't necessarily show whether or how that presence was bad for the markets. Yesterday, my fellow Fool Brian Stoffel took that one step further and called high-frequency trading "just a lot of noise," and concluded that "It's either a positive or a complete non-factor for individual, buy-to-hold investors."

One of the biggest problems we face with figuring out whether high-frequency trading is good, bad, or neutral for long-term investors is that there's much that's unknown about the trading, who's doing it, and for what purpose. Why that is will become clearer in just a moment.

To Brian's point, there's an argument that, for long-term investors, the issue of high-frequency trading isn't something to lose sleep over. At the end of the day, if you're buying a piece of a company to own it for a long period of time, your primary concern should be the dynamics of the business, not the technical stock-market action. Most Fool readers have likely heard the Warren Buffett quote: "I buy on the assumption that they could close the market the next day and not reopen it for five years."

Great, but do we want the market shut down?
Keeping in mind the fact that we're ideally buying companies and not stocks, we should still want a healthy, properly-functioning market that allows us to transact. And there are some signs that high-frequency trading is doing a lot to gum up the markets and cause some serious problems.

Led by founder Eric Hunsader, the folks over at market-data collector Nanex -- the creator of the now-famous high-frequency trading GIF -- have been on a warpath against bad practices among high-frequency traders. Specifically, they're very concerned about the proliferation of quotes by high-frequency traders.

When you log onto, say, E*Trade (Nasdaq: ETFC  ) to make a trade, what you see listed under the bid and ask are quotes -- that is, somebody offering to buy or sell at a certain price. In the normal course of a trader's day, he'll end up putting out lots of quotes, and cancelling many of them. Why? Because he may quote a certain price, see a couple of trades take place, and decide that the stock is moving, and so it's a good idea to cancel the previous quote and put in a new bid or offer at a different price.

As the high-frequency trading industry has grown, though, the number of quotes has exploded – and, mind you, we're talking just quotes here, because actual trading has not grown anywhere near as much. The reason that high-frequency traders are putting out this many quotes isn't entirely clear. In some cases, it may simply be offering and cancelling quotes the same way any market maker would;, but in other cases, it may be programs sending out odd quotes in an effort to mislead other market participants -- think Muhammad Ali pulling a rope-a-dope. In some cases, Nanex has even proposed that high-frequency traders send out a barrage of quotes to create a sort of informational fog of war that gives them a brief trading edge over other participants.

The problems created by this quoting aren't just in the abstract. Here are a few concrete potential outcomes from this flood of quotes:

  • Cost. Exchanges and brokers need to process, manage, and store market data, so as the volume of quoting activity rises, that increases the data-processing burden. Exchanges like NYSE Euronext (NYSE: NYX  ) and Nasdaq OMX (Nasdaq: NDAQ  ) have to keep up with this, as do brokers like E*Trade and TD Ameritrade (Nasdaq: AMTD  ) . That means costly servers, routers, switches, and storage devices. While computerized trading has done much to reduce the cost of trading, there's a concern that this data overload threatens to reverse that trend.
  • Scaring away liquidity. High-frequency, and many other types of traders are, understandably, reluctant to trade when they believe they're getting a bad data feed. When a rush of quotes hits the market, it has the potential to slow everything down, create corrupted feeds, and cause liquidity providers to bow out. Nanex believes that this exact scenario played out during the Flash Crash. It's also a contributor to the 10,693 "micro-flash crashes" -- super-fast bursts of erratic trading -- that Nanex has identified so far this year.
  • Figuring out what the heck is going on. In the wake of the Flash Crash, it took regulators months to put together the forensic trading data from just a single day. Technology is clearly a boon to the markets but, when things go wrong -- and they will, regardless -- it's essential that we have a system that regulators can quickly and easily navigate.

The disappointing answer
It'd be nice if there were an easy, pat answer to this issue like "ban high-frequency trading" or "high-frequency trading is a non-issue." Unfortunately, there's not.

What we need is for regulators to dig into the problem, figure out what's going on -- who's playing by the rules and who isn't -- and set rules that will allow us to take advantage of the latest technologies in the financial markets without the threat from ne'er-do-wells who abuse those technologies. To be sure, this is already happening -- the SEC recently approved a plan for a consolidated audit trail that would help it monitor markets, and it's holding a round-table on technology and automated market systems next month.

Government regulators, however, aren't known for swift maneuvering. The consolidated audit trail, for instance, has been in the works for two years, and doesn't go into effect until October, and gives participants 270 days to submit an audit plan to the SEC. In a race between traders who work in microseconds, and regulators who work in weeks, months, and years, it seems reasonable to worry that regulators will remain a step behind.

And if the SEC doesn't step up its game? Well, there's always crossing our fingers and hoping that the concerns from those like Nanex don't play out. Personally, I've got on my rally cap to root for the SEC proving that it, too, can be fleet-footed.

Motley Fool newsletter services have recommended buying shares of NYSE Euronext and TD Ameritrade Holding. Motley Fool newsletter services have recommended creating a write puts position in TD Ameritrade Holding. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer owns shares of E*Trade, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool’s disclosure policy prefers dividends over a sharp stick in the eye.

Read/Post Comments (8) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 03, 2012, at 5:30 PM, dennyinusa wrote:

    I have a question.

    Since you need to be situated in the same data center as the exchanges servers, why is this not considered insider trading? These locations are not available to everybody who wants to purchase stock.

    A similar case could be made that since the super computers needed are also not available this would again be consider insider trading since these machines are able to get information well before it is distributed to the public.

    Rooting for SEC is a losing battle when many members of congress do not believe in regulations and if they cannot stop the regulation they then will underfund the agency during the budget process. Very are hard to act swiftly when you don’t have the people or resources needed.

    The only way to stop it is to start taxing trades or have a different tax rate for stock held for milliseconds.

  • Report this Comment On September 03, 2012, at 5:49 PM, dgmennie wrote:

    According to the August 2, 2012 Wall Street Journal column "When Will Retail Investors Call it Quits?" Jason Zweig says "The hearts of many small investors have been broken by the serial setbacks of the past few years...."With events like the flash crash and this week's stumble, could buy and hold a company for 15 years and have everything you've built up disappear in five minutes."

    Its becoming ever more obvious that stocks too often become near-certain disaster (now on autopilot thanks to computerized trading) for the vast majority of small investors.

    "Markets spinning out of control and trading machinery gone mad" says Zweig. Amen.

  • Report this Comment On September 03, 2012, at 6:00 PM, DBLBLU wrote:

    I have often thought that the best way to deal with high-frequency traders is to charge them a nominal fee for every quote that they submit.

    Imagine what it would cost a company that submits and cancels thousands of quotes per minute if they had to pay a measly 5 or 10 cents per quote.

    No need for onerous pages-thick regulation or super-sophisticated forensic tracking systems. Just get them to pay for their bad habits. Treat the funds raised as a tax and dedicate it to paying down the national debt.

    However, given that Wall Street owns Washington, this is never going to happen.

  • Report this Comment On September 03, 2012, at 8:05 PM, Tkdunn17 wrote:

    I think the simple answer is a transaction tax per trade - maybe 5 cents per share per trade. Wall Street will hate it, but it will force high frequency traders to evaluate the role they play in the market and the value of the trades they make.

    I don't think anybody can rationally argue that computerized trading has not gotten out of control. As a guy who started writing code 25 years ago, you don't want to leave this sort of thing unchecked - nobody has any idea what may happen if one program goes rogue and starts a domino effect that could be difficult to stop before real damage is done.

  • Report this Comment On September 03, 2012, at 8:18 PM, modeltim wrote:

    If you want regulation to solve the problem, you're a fool if you vote Republican. Yes, that's an opinion but there's a lot of fact buried in there too! They just don't like regulation at all. Dems ain't angels but I do hear a lot of them plugging for better-funded and more effective regulation. What we have now is regulators who lack the skills and resources to police the uberwealthy banksters.

  • Report this Comment On September 04, 2012, at 4:44 AM, WilderMann wrote:

    The obvious answer is a (very low) tax on market transactions, like that proposed by James Tobin. Like any tax, it would benefit the public, and not the banks themselves (as an extra fee would do). The amount of tax due for any transaction must, of course, be based on the dollar volume of that transaction, and not on the number of shares or some other arbitrary measure. The tax rate should be extremely low, much less that 1 percent; so it would not seriously interfere with any investors or day traders who think even one second about what they are doing. But it would either bring high frequency computer trading down to a reasonable level again, or else generate so much revenue from it, that the US budget could be in balance again.

    Everything else we do is taxed in one way or another; why should financial transactions enjoy this unique status of being utterly tax free (only, of course, for insiders, since bank fees and such make life hard enough for the small private investor)?

  • Report this Comment On September 04, 2012, at 7:09 AM, ravens9111 wrote:

    Just look at what happened on Friday. When the Jackson Hole speech was released, the market collapsed. Why? The algos scanned the speech and did not see QE3 in there. After humans read the speech, they read at the end that the Fed is ready if warranted. Then the market recovers. The algos are very dangerous. When they scan news, even if it is not correct, you will see major swings in the market or individual stocks. Even when the circuit breakers are turned on, they aren't always activated. Take DLTR's drop from a couple weeks ago when it plunged 10% in a few seconds at the open. A lot of retail investors surely were stopped out only to see the stock go up shortly after.

  • Report this Comment On September 04, 2012, at 1:50 PM, lowmaple wrote:

    HFT does not hurt patient long term investors. Buy on dips and then place a bid way below the current price and reap the rewards when one of these "disasters" occurs. Over time good companies recover. However a Widermann tax is a great idea.

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