What is High-Frequency Trading and What Does Its Future Hold?

What is high-frequency trading? We take a look at regulation of HFTs and where it might go from here.

Jul 19, 2014 at 11:00AM

What is high-frequency trading? Today we'll look at the regulatory future of HFTs. 

Improving the market-making process 
HFTs interact with many different parties in carrying out their activities. As market makers, their primary interactions occur with exchanges, like the New York Stock Exchange. 


Flickr / Kevan Davis.

It would not be inaccurate to say that the exchanges make a lot of money from HFTs.

These firms pay dearly to have unhindered access to data and previews of trading orders. They also earn rebates for providing liquidity. These activities in and of themselves are not bad, but there is potential for bad deployment. 

Is best price the best way?
For example, HFTs operate on a policy of "best price," but there is a chance that a company with the wherewithal to draw up the price through transaction activity could offer the "best price" without it being the real best price.

I haven't seen hard evidence of this occurring yet (research shows that HFTs improve price efficiency), but some have suggested that enforcing best execution would eliminate these incentives.

Can HFTs provide liquidity consistently? 
Another issue is liquidity. HFTs aren't required to provide liquidity, they're paid for it.

Some research has found that liquidity falls when high-speed firms start competing with each other, which prompts a change in strategy -- they stop making markets and start placing bets on stocks. If we place a lot of, well, stock in the idea that more liquidity in the market is good, then this is an issue that needs to be considered when drafting new policies.  

More on conflicts with dark pools 
Given the primacy of information for an HFT, it's unfortunately not all that surprising that a few scandals involving dark pools have recently come to light.

These scandals -- first with Bank of America and the New York Stock Exchange (among others), sued by Providence, RI, and now with Barclays and the New York Attorney General -- not only make HFTs look predatory but make the operators of dark pools look rather two-faced.


Flickr / gezzelle.

In essence, dark pools exist to protect the anonymity of large traders, those whose activities could have an effect on prices in the open market.

This is obviously of great interest to HFTs, who seek to improve price efficiency. It's recently been alleged that certain dark pools have provided access to HFTs without informing their customers. In the case of Barclays, the firm is alleged to have gone so far as to hide evidence that HFTs were even in the dark pool.

Now, fraud by banks is obviously already illegal. These firms are regulated, so one would hope and presume that incidents such as these come to light rather quickly. Mary Jo White, Chairman of the SEC, has suggested that HFTs register as broker-dealers, which would also bring them under the scrutiny of regulators.

The future of regulation technology
Funny enough, regardless of where regulation goes, the SEC is benefiting from HFT technology in its activities.

Gregg Berman, a physicist who leads the SEC's Office of Analytics and Research, was shocked to find that HFTs had a much clearer and nuanced view of the market than the SEC. So, in 2012, the SEC agreed to pay Tradeworx, an HFT, to use its software platform.

The program, Midas, allows the SEC to monitor trading and rapidly pick up on irregular activity. Last year, it was reported that the efforts of Berman's group assisted the FBI in an investigation into manipulative trading practices by HFTs.

Amazing innovation? Well, I think so. While the program was designed by an HFT, it provides uninhibited access to raw data, which the SEC can now analyze as quickly as everyone else. This is a major step forward, considering that most oversight activity relies on the reporting of regulated entities for information.  


Our markets are not broken and they are not static. In that sense, our work on market structure is never finished — the speed with which technology and markets change makes that impossible — instead, we must always be focused on what in our market structure can be improved for the benefit of investors and companies.  Mary Jo White, Chairman of the SEC

HFT isn't going anywhere, but it's certainly being looked at with a critical eye.

I think we'll see more stringent rules regarding conflicts of interest and market-making, though it remains to be seen what those rules will be. It's a complicated issue, one that touches on market efficiency, fairness, and accuracy -- time will tell where the regulators take us.  

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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