High Frequency Trading: You might not have heard of it now, but get ready, because it's going to be
everywhere in the next few weeks. After the New York Times' exposed how advanced Wall Street computers can execute impossibly complicated, and possibly unfair, stock trades, Sen. Chuck Schumer
(D-NY) asked the SEC to ban certain types of high frequency trading, or HFT. But what is HFT exactly, how does it work?
There is still a lot of uncertainty about how exactly these trades are executed. As the Times reported in a very clear graphic, computers can "peek" at trade orders 0.3 seconds before they are executed, and actually buy the stock milliseconds before it goes up in value. During this process they "ping" (or listen to) the prices, learning how much people are willing to pay by making a flash bid -- a bid to see the maximum price other buyers are willing to pay.
How does that work? Here's a down-and-dirty analogy in which I'll play the role of the flash trader. Imagine if eBay had a rule where you could cancel your bid within 1 second. I put up some stuff on ebay, and you place a bid for it. Then I place a bid that is higher than the current bid to see if that becomes the new highest bid. If it is, I cancel it within milliseconds. Remember, I don't want to buy the product -- I just want to drive the price higher! This is similar to what critics of HFT think is going on; HFT is able to ping prices with bids that exist for only milliseconds to see how much other buyers are willing to pay to squeeze out the maximum profit.
There's going to be a lot of terminology thrown around when people talk about this, and rightfully so since it is a very technical issue. But the economic ideas are simple, and I want to give you the water cooler guide to thinking through the relevant issues in the debate. When you hear discussion about this going forward, think of how the points made influence these concepts.
As you can see from the quick eBay analogy above, being able to see someone else's information, when they can't see yours, makes for terrible markets. Beyond issues of fairness and equity, which are incredibly relevant here, this also leads to an issue of bad prices. The information reflects only part of what you believed about the stock in question; computers took advantage of your situation, but the information that others see as a result of the front-running doesn't reflect what you actually believed. You hear stories about stock prices jumping all kinds of crazy values, with crazy volume numbers and volatility, because of a few stock purchases, and these price movements reflect the HFT. Now remember that the feedback mechanism of stock prices - if you are a Hayekian - is the whole point of having a market. If trading in markets doesn't aggregate information among many diverse parties but instead turns the price mechanism into a roulette wheel played out by supercomputers ransacking your 401(k) - because believe me, your 401(k) is a great target - what's the point? Does that have any more information than the tyrant social planner?
The strongest claim in favor of HFT is that it is providing liquidity to the financial markets. More liquidity in markets is usually considered to be a good thing, and as such they are being rewarded for providing a service. There's a problem with this though - they have no obligation to provide liquidity. There's no formalized procedure in which they post prices with certain time limits. They, and the HFT practitioners have been very upfront about this, have no obligations when it comes to providing liquidity. And it is very likely that they won't step in when the financial markets need them the most.
So in this sense, liquidity from HFT is like having an airbag in your car that works all the time except when you are in a car accident. It isn't there when you most need it, and it encourges you to drive a bit faster, and take turns a bit sharper, because you think you are protected. So instead of being a risk management tool everyone is aware of, it is instead misinformation.