Does high-frequency trading increase systemic risk

Many OTC stocks have more than one market-maker. Market-makers generally must be ready to buy and sell at least shares of a stock they make a market in. As a result, a large order from an investor may have to be filled by a number of market-makers at potentially different prices. There can be a significant overlap between a "market maker" and "HFT firm". HFT firms characterize their business as "Market making" — a set of high-frequency trading strategies that involve placing a limit order to sell or offer or a buy limit order or bid in order to earn the bid-ask spread.

By doing so, market makers provide counterpart to incoming market orders. Although the role of market maker was traditionally fulfilled by specialist firms, this class of strategy is now implemented by a large range of investors, thanks to wide adoption of direct market access. As pointed out by empirical studies, [35] this renewed competition among liquidity providers causes reduced effective market spreads, and therefore reduced indirect costs for final investors.

Some high-frequency trading firms use market making as their primary strategy. Building up market making strategies typically involves precise modeling of the target market microstructure [37] [38] together with stochastic control techniques. These strategies appear intimately related to the entry of new electronic venues. The study shows that the new market provided ideal conditions for HFT market-making, low fees i. New market entry and HFT arrival are further shown to coincide with a significant improvement in liquidity supply.

Quote stuffing is a form of abusive market manipulation that has been employed by high-frequency traders HFT and is subject to disciplinary action. It involves quickly entering and withdrawing a large number of orders in an attempt to flood the market creating confusion in the market and trading opportunities for high-frequency traders. Much information happens to be unwittingly embedded in market data, such as quotes and volumes. By observing a flow of quotes, computers are capable of extracting information that has not yet crossed the news screens.

Since all quote and volume information is public, such strategies are fully compliant with all the applicable laws. Filter trading is one of the more primitive high-frequency trading strategies that involves monitoring large amounts of stocks for significant or unusual price changes or volume activity. This includes trading on announcements, news, or other event criteria.

Software would then generate a buy or sell order depending on the nature of the event being looked for. Tick trading often aims to recognize the beginnings of large orders being placed in the market. For example, a large order from a pension fund to buy will take place over several hours or even days, and will cause a rise in price due to increased demand. An arbitrageur can try to spot this happening then buy up the security, then profit from selling back to the pension fund. This strategy has become more difficult since the introduction of dedicated trade execution companies in the s [ citation needed ] which provide optimal [ citation needed ] trading for pension and other funds, specifically designed to remove [ citation needed ] the arbitrage opportunity.

Certain recurring events generate predictable short-term responses in a selected set of securities. Another set of high-frequency trading strategies are strategies that exploit predictable temporary deviations from stable statistical relationships among securities.

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Statistical arbitrage at high frequencies is actively used in all liquid securities, including equities, bonds, futures, foreign exchange, etc. Such strategies may also involve classical arbitrage strategies, such as covered interest rate parity in the foreign exchange market , which gives a relationship between the prices of a domestic bond, a bond denominated in a foreign currency, the spot price of the currency, and the price of a forward contract on the currency.

High-frequency trading allows similar arbitrages using models of greater complexity involving many more than four securities. Index arbitrage exploits index tracker funds which are bound to buy and sell large volumes of securities in proportion to their changing weights in indices. If a HFT firm is able to access and process information which predicts these changes before the tracker funds do so, they can buy up securities in advance of the trackers and sell them on to them at a profit.


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Company news in electronic text format is available from many sources including commercial providers like Bloomberg , public news websites, and Twitter feeds. Automated systems can identify company names, keywords and sometimes semantics to make news-based trades before human traders can process the news. In these strategies, computer scientists rely on speed to gain minuscule advantages in arbitraging price discrepancies in some particular security trading simultaneously on disparate markets.

Another aspect of low latency strategy has been the switch from fiber optic to microwave technology for long distance networking. Especially since , there has been a trend to use microwaves to transmit data across key connections such as the one between New York City and Chicago.

High-frequency trading strategies may use properties derived from market data feeds to identify orders that are posted at sub-optimal prices. Such orders may offer a profit to their counterparties that high-frequency traders can try to obtain. Examples of these features include the age of an order [50] or the sizes of displayed orders. The effects of algorithmic and high-frequency trading are the subject of ongoing research.

High frequency trading causes regulatory concerns as a contributor to market fragility. Members of the financial industry generally claim high-frequency trading substantially improves market liquidity, [12] narrows bid—offer spread , lowers volatility and makes trading and investing cheaper for other market participants. An academic study [35] found that, for large-cap stocks and in quiescent markets during periods of "generally rising stock prices", high-frequency trading lowers the cost of trading and increases the informativeness of quotes; [35] : 31 however, it found "no significant effects for smaller-cap stocks", [35] : 3 and "it remains an open question whether algorithmic trading and algorithmic liquidity supply are equally beneficial in more turbulent or declining markets.

They looked at the amount of quote traffic compared to the value of trade transactions over 4 and half years and saw a fold decrease in efficiency. This makes it difficult for observers to pre-identify market scenarios where HFT will dampen or amplify price fluctuations. The growing quote traffic compared to trade value could indicate that more firms are trying to profit from cross-market arbitrage techniques that do not add significant value through increased liquidity when measured globally. Economies of scale in electronic trading contributed to lowering commissions and trade processing fees, and contributed to international mergers and consolidation of financial exchanges.

The speeds of computer connections, measured in milliseconds or microseconds, have become important. For example, in the London Stock Exchange bought a technology firm called MillenniumIT and announced plans to implement its Millennium Exchange platform [66] which they claim has an average latency of microseconds. Off-the-shelf software currently allows for nanoseconds resolution of timestamps using a GPS clock with nanoseconds precision. The brief but dramatic stock market crash of May 6, was initially thought to have been caused by high-frequency trading.

In the aftermath of the crash, several organizations argued that high-frequency trading was not to blame, and may even have been a major factor in minimizing and partially reversing the Flash Crash.

EconPapers: Does high-frequency trading increase systemic risk?

However, after almost five months of investigations, the U. Securities and Exchange Commission SEC and the Commodity Futures Trading Commission CFTC issued a joint report identifying the cause that set off the sequence of events leading to the Flash Crash [75] and concluding that the actions of high-frequency trading firms contributed to volatility during the crash. In the Paris-based regulator of the nation European Union, the European Securities and Markets Authority , proposed time standards to span the EU, that would more accurately synchronize trading clocks "to within a nanosecond, or one-billionth of a second" to refine regulation of gateway-to-gateway latency time—"the speed at which trading venues acknowledge an order after receiving a trade request".

Using these more detailed time-stamps, regulators would be better able to distinguish the order in which trade requests are received and executed, to identify market abuse and prevent potential manipulation of European securities markets by traders using advanced, powerful, fast computers and networks.

The fastest technologies give traders an advantage over other "slower" investors as they can change prices of the securities they trade. As a result, the NYSE 's quasi monopoly role as a stock rule maker was undermined and turned the stock exchange into one of many globally operating exchanges.

The market then became more fractured and granular, as did the regulatory bodies, and since stock exchanges had turned into entities also seeking to maximize profits, the one with the most lenient regulators were rewarded, and oversight over traders' activities was lost. This fragmentation has greatly benefitted HFT. High-frequency trading comprises many different types of algorithms.

High-frequency trading has been the subject of intense public focus and debate since the May 6, Flash Crash.

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In their joint report on the Flash Crash, the SEC and the CFTC stated that "market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets" [75] during the flash crash. Politicians, regulators, scholars, journalists and market participants have all raised concerns on both sides of the Atlantic. She said, "high frequency trading firms have a tremendous capacity to affect the stability and integrity of the equity markets.

Currently, however, high frequency trading firms are subject to very little in the way of obligations either to protect that stability by promoting reasonable price continuity in tough times, or to refrain from exacerbating price volatility. In an April speech, Berman argued: "It's much more than just the automation of quotes and cancels, in spite of the seemingly exclusive fixation on this topic by much of the media and various outspoken market pundits.

Four Big Risks of Algorithmic High-Frequency Trading

I worry that it may be too narrowly focused and myopic. The Chicago Federal Reserve letter of October , titled "How to keep markets safe in an era of high-speed trading", reports on the results of a survey of several dozen financial industry professionals including traders, brokers, and exchanges. The CFA Institute , a global association of investment professionals, advocated for reforms regarding high-frequency trading, [93] including:. Exchanges offered a type of order called a "Flash" order on NASDAQ, it was called "Bolt" on the Bats stock exchange that allowed an order to lock the market post at the same price as an order on the other side of the book [ clarification needed ] for a small amount of time 5 milliseconds.