High Frequency Trading
This encompasses the use of computational algorithms to trade securities at high speed; this mainly concerns the holding of short positions in regards to seconds and even fractions of seconds. The competition in this sector is mainly from other high frequency trading systems. It does not follow the common trading approaching of buying and holding, but through carrying out many trades within a shorter period of time can lead to a higher Sharpe ratio (the calculation between trade risk and reward). However there are concerns that considerable uptake of this system can introduce greater systemic risk, with the most recent example being the 2010 “flash crash” where there was an instant withdrawal of liquidity from the market.
However, recent study has shown that high frequency trading (HFT) can actually contribute to market efficiency, as it helps to reduce what is seen as “noise” (short term price volatility). The risk seen in HFT is mainly concern from its extended usage as it accounts for half the volume of US equity trading, and 35% of Europe.
How does HFT provide better efficiency in markets?
The first advantages to HFT were noted in the “Foresight” report which published data that revealed the improved liquidity in markets, and a reduction in transaction costs. Additionally, it promotes what is seen as “price efficiency” where the trading occurs in the direction of permanent price change, rather than pricing errors in short term volatility or transition between equities.
The article from the FT looks at how governments are considering introducing some form of regulation for these markets to ensure there is no looming systemic risk. However there are many that comment that incorrect regulation will stifle the benefits found in HFT, additionally regulation may hinder the current “highly competitive environment” which HFT produces.
It will be interesting to see what kind of regulation will be produced in regards to HFT, as it is clear that it requires a very different approach from the intermediation sector which is already highly regulated. Although HFT on the surface seems like a quick way of making money, it is important to note the high barriers to entry, in that many servers are need for computational power, and each fraction of a second advantage can mean a whole array of different profits.
For the Article: http://on.ft.com/1gmYm5d