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Fast, faster. High-frequency traders.

Milliseconds count: With the aid of supercomputers and fast data connections, high-frequency traders try to make a profit trading on the stock market. How does this automated equity trading work?

High-frequency traders as free riders

If you were playing a guessing game and had to describe the job profile of high-frequency traders, the picture you painted would be interesting. They are probably involved in every other transaction on the exchange, but they hardly create any market liquidity. They often pursue proprietary investment strategies, but they are concerned with neither price nor value. Their investments are low-risk, and yet they increase overall market volatility. High-frequency traders are considered free riders of an existing exchange infrastructure, but they are subject to hardly any regulation.

The automated trading systems, still new at the time, proved to be disastrous by accelerating the 20-percent flash crash of the Dow Jones Index on only one trading day in 1987. Unfortunately, automated systems have a counterproductive effect when they are activated by all market participants at the same time. Another flash crash took place late last year. That made December of 2018 the worst one since 1931.

The history of stock trading

Historically, stock exchanges and markets were organized around traders. Brokers break up customer orders into smaller orders so they can conduct them at prices that are as neutral as possible. For that purpose, traders often had to maintain their own holdings, making their business capital intensive.

This form of trading was replaced with electronic trading systems more and more starting in the 1990s. They executed client orders anonymously on the basis of rules. In other words, they brought together supply and demand on the exchanges. That did more than save time, expense, and capital. Automated trading on stock exchanges prevented misuse, strengthened confidence in the markets, increased liquidity, and ultimately improved capital allocation.

overview-of-stock-market-trading-systems

Overview of stock market trading systems

Today's electronic trading systems can be divided into three categories.

Source: Fidelio Tata

High-frequency traders' share of trading on the exchange growing

High-frequency trading strategies represent a subcategory of fully automated trading systems. They are mainly known for their speed and typically have a brief informational advantage between the signal and trade.

The Research Service of the US Congress estimates that high-frequency trading (HFT) has gained a large share of trading on the stock market over the past ten years. In the US, more than 55 percent and over 40 percent of all stock trades in Europe are executed using HFT. If other, fully automated trading strategies are counted as part of high-frequency trading, then, according to estimates of the Wall Street Journal, only 15 percent of all transactions today are initiated by investors with a focus on fundamentals, while 85 percent are triggered by computers.

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Transactions in global stock market trading

Today, computers generate 85% of the global trading volume.

Source: Fidelio Tata, numbers cited from the Wall Street Journal

How high-frequency traders increase market volatility

Supercomputers allow high-frequency traders to perform statistical price arbitrage within a matter of milliseconds. These kinds of strategies make no assumptions about prices or value. Instead, they represent a dubious arms race in which the fastest computer, the fastest data connection, and the best software win. With the goal of placing their own orders faster than their competitors, high-frequency traders rent shelf space for their computers directly on the server racks of the respective stock exchanges.

Because the holding periods of high-frequency transactions usually last only fractions of a second, every transaction is extremely low-risk when considered individually. Because of the brief holding periods, high-frequency traders do not need to know anything about "correct" pricing. They leave time-consuming provision of liquidity and price calculation up to the investors interested in fundamentals. Whether such high-frequency transactions truly add liquidity to the markets is debatable. Hardly disputed, however, is that high-frequency trading makes markets more volatile, sometimes even dramatically.