Busting the Top 5 Myths About HFT

Remember the HFTs?

Not much has been said recently about these so-called nefarious exploiters of the market structure. But wait, the news this week from the U.K’s Financial Conduct Authority that found that high-speed trading practice of “latency arbitrage” is costing investors $5 billion a year. According to the FCA, traders and hedge funds who use high speed trading methods to gain an advantage in effect impose a “tax” on other investors who end up paying more to trade.

But that’s not exactly true, according to Jeff Mezger, director of product management at Transaction Network Services (TNS), a commonly held myth is that high-frequency trading (HFT) firms make things more expensive for everyone. Actually, HFT firms provide the liquidity needed to fuel the market, which makes it easier for investors to buy and sell.

Here, in his own words, Mezger spells out the Top 5 myths surrounding HFTs as he sees it.

Myth No. 1: High-frequency trading (HFT) firms make everything more expensive for everyone.

Many people, both within the financial service industry and outside it, have a perception that HFT firms are predatory; they make all the money while individual investors lose – a zero-sum game.

But that’s actually not true. For markets to work properly, you need lots of people participating and lots of money moving in and out from various sectors – i.e., lots of liquidity.

HFT firms provide the liquidity needed to fuel the market, which actually makes it easier for individual investors to buy and sell: Without a certain amount of liquidity in a particular market or commodity, they become more expensive.

Some allege HFT firms were responsible for the 2010 Flash Crash, but the crash actually proves these points; liquidity evaporated, everyone pulled out, and shares went down to a penny because no one wanted to buy.

In fact, HFT firms can help prevent exactly these kinds of issuesby providing the liquidity that acts as a shock absorber for the natural ebb and flow of individual investors’ trades.

Myth No. 2: HFT firms have special access to data.

There’s a perception that HFT firms can gain information about the exchanges, including price, through certain backchannels that regular investors don’t have access to.

That’s not quite true. These exchanges are heavily regulated by the Securities and Exchange Commission (SEC) and the U.S. Commodities Futures Trading Commission (CFTC), and one of the regulations is a mandate granting everyone equal access.

There is a caveat to this one, however. The exchanges have different levels of service in terms of the market data they provide; the more someone is willing to pay, the faster they get information. This means it’s possible, in theory and practice, for HFT firms to get better information faster, but the fact remains that it’s available to everyone – even though not everyone wants to pay for it.

There have been outcries in the past against HF traders who received information about the results of their own trades before the market does, with some saying this grants an unfair advantage. Yet HFT firms only get this information as it pertains to their own trade activity; they effectively pay for the right to get data faster in exchange for taking on risk.

Myth No. 3: HFT firms drive smaller players out of the market.

Another assumption is that HFT firms monopolize exchanges; through the dollars and technology they bring, they usurp some of the smaller players, thus driving them out.

The first part does happen: It’s no secret that HFT firms bring a lot of money into an exchange (which is a good thing, as we saw in Myth No. 1). The myth here is that smaller players just hang up their hats and go home.

The smart ones, however, know how to survive, by taking the same strategy they used in competitive, mature markets and airdropping it into emerging markets.

Say a smaller firm makes a killing trading short-term interest rates on the CME, until the HFT firms come into the Chicago market and create more competition. Instead of closing up shop, what that smaller firm should do is look at other avenues.

The Australian market (ASX) also trades short-term interest rates. This smaller firm can take its strategy; trade on another, less competitive exchange, like the ASX; and continue to reap the rewards.

And while small firms may bemoan their lack of international resources, in fact, service providers are making it a snap to connect globally. The firm doesn’t need employees physically in Australia, or deep knowledge of the network routes and hardware providers there, or local broker relationships. Service providers bring all of this, taking the tough parts off the firm’s hands and creating access formerly only available to global conglomerates.

Exploring these new avenues is part of the “adapt and adopt” mentality that anyone involved in the financial service industry needs to have these days.

Myth No. 4: An HFT firm’s business model is solely based on speed.

Some believe HFT firms make their money only because of the speed at which they trade – they get from one place to the other faster than anyone else. While this is the bulk of their business, it’s not the entirety of it.

Like innovators in any industry, HFT firms also seek smarter ways of doing things via technology. We throw around the word “disruptive” so often these days because the new normal is the 2.0 version of anything; once a technology or methodology exists, you can expect that someone is going to find a better way of doing it.

Instead of depending on speed exclusively, some firms are looking to other ways to trade – for example, building a trading strategy on clock sync technology, which synchronizes clocks around the world based on location to create an advantage.

The future belongs to the disruptors (and the disruptors of those disruptors); it’s how we keep moving forward as a species. HFT firms are no different.  

Myth No. 5: HFT firms do everything themselves.

Many accept the idea that HFT firms often are in a position to cull all their own information, build their own microwave towers, run all their own network routes, etc., and smaller firms don’t have the ability to do that, so that means they can’t compete.

False. While this is true in some markets – no, a smaller firm is not able to build their own shortwave radio towers between Chicago and London– it’s not true on a global scale.

Myth No. 3 touched on the idea of developing strategies for emerging and smaller markets and using service providers to allow smaller firms to compete. Here’s an open industry secret: HFT firms use these services as well, in emerging markets like Korea and Taiwan, giving them boots on the ground in a market they don’t know themselves.

The idea that smaller firms can’t compete because they don’t have the money to do everything themselves is a myth; service providers have leveled the playing field in recent years, creating friendly competition and ensuring even small firms can play in the markets.

Moving Forward

The prevalence of these five myths points to a lack of understanding about many aspects of high-frequency trading practices and advantages, and it’s important to set the record straight.

Having a better grasp of how HFT firms operate – and the ways smaller firms can capitalize on their advantages to become fierce adversaries – will move the industry forward and fuel competition, keeping markets humming and making everyone a buck.