The Controversy behind High Frequency Trading

Apr 17, 2014

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
A few weeks ago, financial journalist Michael Lewis released his latest book entitled "Flash Boys". The book is about High Frequency Trading (HFT) and how it impacts the markets and investors. HFT is a method of algorithmic trading that makes trades at lightning fast speeds. Trade times and holding periods are measured in fractions of a second.

In Lewis' book, he talks about how HFT makes profits at expense of other investors. In particular, when large institutional investors make trades, they tend to suffer excess slippage costs whenever they execute large orders. On an individual transaction, they may lose up to 0.1% of the transaction value to HFT. For a single order, this is not large, but it does add up over many transactions. As a result, the existence of HFT reduces the returns for institutional investors. Retail investors are less impacted because their order sizes are considerable smaller.

Retail investors are impacted through the mutual funds or exchange traded funds or pension funds they are invested in. Since these large institutional investors earn lower returns due to HFT, the individuals invested in these funds experience lower returns.

The primary controversy behind HFT is that it hurts institutional investors, it can lead to greater market volatility, and it puts other investors at an unfair disadvantage. The flash crash that took place in the US in May 2010 has been blamed on HFT. It is important to stress that there is no conclusive evidence that HFT causes all these problems, but this is the majority consensus at the moment. There are indications that HFT is good for markets. In particular, it has resulted in higher liquidity and subsequently lower spreads. Currently, US regulators are looking into the impacts of HFT, and it is possible that they will implement regulations to curb the impact of HFT on the markets.

In India, HFT is not as large as it is in the US or other Western markets. However, it is a growing segment of the market. Algorithmic trading makes up around 1/3 of trade volume in Indian share markets, though not all of this is HFT. The Indian market regulator SEBI is currently looking into the impact of HFT on the Indian markets. It is likely they will seek to regulate these activities in the near future.

In this week's Equitymaster Club forum, we are asking the question, "Is HFT good or bad for financial markets?" We encourage you to please login and post your views.

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is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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