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What’s the Frequency, Kenneth?

BLOG, MARKETS & ECONOMICS, MOST RECENT  |  10 Apr 2014

High Frequency Traders

Cartoon by Schillerstrom (Source)

The rock band REM wrote the song, What’s the Frequency, Kenneth?, back in the early 90’s in reference to an incident in 1986. Two men attacked Dan Rather, the CBS news and 60 minutes
reporter, and kept repeating that phrase over and over. This tidbit of information has nothing to do with the content of this article, except that that the phrase “High Frequency Trading” or “HFT” and the CBS show, 60 Minutes, have been a hot topic of late.  Michael Lewis, the well-known author, of books such as “Moneyball” and “The Big Short” released a new book called “Flash Boys”, and the television program “60 Minutes” ran a segment about the book.

Flash Boys is about a small group of Wall Street guys who figure out that the U.S. stock market has been rigged for the benefit of insiders and that, post–financial crisis, the markets have become not more free but less, and more controlled by the big Wall Street banks. Working at different firms, they come to this realization separately; but after they discover one another, the flash boys band together and set out to reform the financial markets. This they do by creating an exchange in which high-frequency trading—source of the most intractable problems—will have no advantage whatsoever. Amazon.com

What is High Frequency Trading or HFT?

HFT is a type of trading using very high powered, sophisticated computers and algorithms to rapidly trade securities. Rapidly is defined as making thousands of trades per minute and moving in and out of short term positions, the goal is to profit by a fraction of a penny or so in every trade.  It may not sound like much, but when this is done millions of times in a trading day, you start talking about millions of dollars in a day. Now that’s real money!

Thirty Millisecond Advantage

Source: The New York Times

It is estimated that HFT may make up over 50% of the daily trading in U.S. markets. The main uproar has been that HFT most affects smaller, retail investors that buy index funds and mutual funds. As you can see in the chart above “The 30 Millisecond Advantage”, these computers can see the order flow before the general market and can buy the shares ahead of the index fund that placed the order. They mark them up a penny or so per share and sell to the fund placing the large order at the higher cost. Some estimates place this cost (as a reduction in their annual return) for investors to as much as .21% to .28% annually for an S & P 500 Index fund.

HFT is not exactly a new phenomenon in the markets. Such strategies have been in existence for over a decade. However, the computers and the technology keep getting better. Thus, the role of humans as intermediaries in the financial markets to execute trades has been greatly diminished over the last several years. It has just started to receive more attention from the mainstream media and the general public with Lewis’ new book and the 60 Minutes segment.

Proponents maintain that HFT has been instrumental over the years in greatly increasing liquidity in the markets. This has led to reduced trading costs to investors (lower commissions) and more efficient stock prices with less spread between buyers and sellers.  (Remember the days when stocks were quoted in 1/8 and 1/4 increments). HFT is also responsible for a large portion of the market making in the stock market which is needed to have an orderly exchange.

Critics say that HFT makes for more fragile markets and increases the potential for extreme market movements such as the Flash Crash of May, 6, 2010. These same critics contend that when the market needed HFT the most, they were nowhere to be seen. The market was cascading downward because these firms had withdrawn their bids for stocks and created a vacuum that caused the steep decline for a brief time that day.

U.S. Flash Crash

This is a very complex subject and this article is just a brief overview of HFT. “Flash Boys” is a good read even if you are not a market expert. The author is a great story teller, and incorporates everything into something fairly easy to read.  You will likely continue to hear a lot more on this subject as the SEC and FBI appear to be getting more involved in looking into this to see if it warrants closer scrutiny. There likely will be some additional regulation if it is found that HFT costs individual investors’ money and reduces the confidence people have in the markets. But, like a lot of things where the SEC is concerned, this will take some time.