High frequency trading (HFT) received a lot of unwanted attention with Michael Lewis' recent book Flash Boys, which contends that HFT is a rigged system that inherently enriches a set of large traders at the expense of the average investor.
Is the process really as damaging as Michael Lewis suggests? Let’s start with how HFT works.
High Frequency Trading — sometimes called Speed Trading — makes use of high-powered computers and streamlined connections to place a large number of trading orders at extremely fast speeds. By beating others to exchanges, they take advantage of the best price. In some cases, HFT traders use co-location, placing their servers physically as close as possible to the servers of the stock exchanges to decrease the trading time even further.
What is the harm in this, and why is this considered rigging? Gaps in executing trades have existed as long as the stock market has existed, and arguably, the system is more efficient than it ever has been. The answer lies in a closer inspection of HFT and its origins.
HFT as it is known today gained in popularity when stock exchanges provided incentive for firms to provide increased liquidity and competition for current quotes. So-called SLPs (supplemental liquidity providers) provide this for an extremely small fee ($0.0015 in 2009). When multiplied over huge numbers of transactions, this provides a large incentive to trade many shares and trade them often.
Thus, HLT traders deal primarily in large volumes of trades, with algorithms that analyze the market conditions and take advantage of them. In essence, by seeing the trends first at the "nearest" exchanges and analyzing what is likely to happen, they can race ahead to a "farther" exchange, buy at the current lower price there and sell immediately after at the upcoming higher price – all within fractions of a second.
The ability to both see a pattern and act before others can react, along with charges that HFT is just engaging in quick ("flash") exchanges without caring anything about the stock or its ultimate value, is what leads to charges of rigging and malfeasance.
One of the major flaws in Lewis' premise is that, effectively, the HLT's are competing with each other more than with the average investor. Matthew Phillips of Bloomberg Businessweek described it this way: "Speed traders aren't competing against the Etrade guy, they're competing with each other to fill the Etrade (NASDAQ: ETFC) guy's order."
People tend to think of trading orders as one massive series of lanes all converging at the same exchange and competing for the same stock, but the actual trading path is more analogous to a subway map. Your simple order of 100 shares of the average stock is just as likely to be filled at a wholesaler such as UBS (NYSE: UBS), KCG (NYSE: KCG), and Citigroup (NYSE: C), never even making it to a public exchange.
Combine this with an increasing number of alternate exchanges known as dark pools, and the tracking of trading paths becomes quite the exercise in cat herding. An excellent graphic on how orders get filled may be found at Bloomberg BusinessWeek.
Brad Katsuyama, one of the protagonists in Lewis' book, created Investors Exchange (IEX) to foil HFTs specifically. By effectively creating an internal delay mechanism, it becomes very difficult for HFTs to operate on IEX.
It remains to be seen if any other exchanges will follow suit with IEX. It seems more likely that any trader that can invest in the technology will catch up, and HFT will become increasingly less profitable though competition – although regulations could always throw a wrench in the works.
The Senate has already begun hearings aimed at the rebate and incentive systems (known as "maker-taker") that feed HLTs. As it is, brokers can be tempted to shop for rebates instead of for the best prices for their clients, given that the activity at that level has very little transparency.
Expect some changes over time, either from the regulatory side or from HFTs and brokers taking their own actions to blunt regulation. However, don't expect HFT to go away. It has increased market efficiency, and if used properly, it is a valuable liquidity tool.