Lentis/Program and High Frequency Trading

Introduction

Since its beginning, stock and option trading has been an activity often characterized by risks, rewards, and unpredictable volatility. With the advent of the high-speed microprocessors and the internet, High-Frequency Trading (HFT) has emerged as a new player in stock trading. The technical capabilities of HFT has resulted in new trading methodologies, redefining the traditional notions of risks, reward and volatility.

Background

When firms buy or sell large quantities of stock there are often small, temporary changes in the stock price. Since 1998, when the United States Securities and Exchange Commission (SEC) allowed computerized transactions, HFT firms have sought to use computer algorithms to analyze incoming market data and make rapid buy and sell transactions to exploit these temporary price changes, often for profits of a fraction of a cent . Transactions occur on the order of milliseconds and in huge volumes. According to the TABB group, in 2009, HFT accounted for 61% of U.S. equity trades and made net profits of over $13 billion. However, only 2% of all U.S. trading firms are High Frequency traders. HFT firms are profitable because of the speed at which they can take advantage of changing market prices. Faster transactions are more profitable because firms can capitalize on the small price changes before others, including competing HFT firms. In order to transact quickly, HFT firms rely on co-location and low-latency hardware. Co-location is when an HFT firm places their servers geographically close to those of the market to realize speed advantages through advantageous network routing. These servers are fitted with super low-latency technology to further reduce the communication delay associated with transmitting data. The TABB group estimates that in 2009 brokerage firms spent $1.8 billion on high speed, low latency data centers.

The FlashCrash

"S&P Market Value (in blue) and Order Flow Toxicity (in red)"

The Flash Crash refers to an incident on May 6, 2010 when the Dow Jones Industrial Average plummeted by over 600 points (approx. 5% of its total value, $860 billion) in a matter of minutes . The drop was followed by an immediate rebound. Although the day began with significant volatility due to the debt crisis in Greece, the primary contributor to this market volatility, according to 80% of U.S. retail advisers, was the "overreliance on computer systems and high frequency trading". On this particular day, a mutual fund was attempting to sell a very large number of E-Mini S&P 500 contracts. With competition from High Frequency Traders, the market was quickly depleted of buyers. This triggered a negative feedback loop where HFT programs attempted to sell investments to at lower and lower prices to minimize short term losses. This drove the price of the E-mini down 3% which in turn spilled over to the equities markets. These negative trends continued until computer systems paused trading temporarily. A joint report by the SEC and CFTC claimed that

"At 2:45:28 p.m., trading on the E-Mini was paused for five seconds when the Chicago Mercantile Exchange ('CME') Stop Logic Functionality was triggered in order to prevent a cascade of further price declines. In that short period of time, sell-side pressure in the E-Mini was partly alleviated and buy-side interest increased. When trading resumed at 2:45:33 p.m., prices stabilized and shortly thereafter, the E-Mini began to recover, followed by the SPY."

Although the markets recovered a majority of the loses by the end of the trading day, the event brought HFT into the limelight.

Technological Arms Race

High frequency trading incites a technological arms race between trading firms. Network latency is a primary competitive advantage in the industry where micro and milli seconds could translate to millions of dollars. As a result, firms invest billions in ultra low-latency networks. Network infrastructure companies, such as Cisco, have developed a series of network solutions targeted specifically at high frequency traders . HFT is a lucrative business model that is laying down the technological groundwork for years to come. Rampant technological growth is blending the boundaries of finance and engineering, changing the business ecosystem and adding to the overall confusion about HFT.

In the 1970s the United States began to see 'quants', quantitative analysts, bring mathematical models and computational technology to the finance industry. Quants capable of algorithmic trading became a hot commodity. Algorithmic trading succeeded on a blend of mathematical and software skills rather than on hardware and networking. HFT in the United States is promoting the skills of network engineering experts to a level of prestige occupied by quants. The traditional idea of the quant is no longer safe as companies like Lime Brokerage LLC continue to succeed in HFT by melding "technical acumen with trusted Wall Street trading experience" HFT is changing what is considered valuable in the finance industry by blending technology with trading.

Another impact of the this 'arms race' is the development of a two-tiered market that separates high-frequency trading firms from non-high-frequency trading firms. As more money is invested in developing the low-latency technological infrastructure it becomes increasingly difficult for new firms to enter and innovate the HFT market. Industry leaders, like Lime Brokerages's CEO Jeff Wecker believe that the single most important challenge facing HFT are the public and political misperceptions . The reliance on bleeding edge technology in HFT may be a key contributor to conceptions and misconceptions of the industry.

Subsequent Impact of Low Latency Networks

Although a direct relation may not yet be evident, the low latency technology that stems from HFT has the potential to improve many fields and industries. While most web based applications are bandwidth dependent (YouTube, web based shopping etc.), applications such as Voice over Internet Protocol (VoiP) are dependent on network latency. Inorder for VoiP calls to appear lag free there needs to be a round trip voice delay of less than 250 ms. The ultra low latency network designs developed for HFT can be applied to improve larger networks that provide service to households and businesses. These faster networks would enhance data transmission, reduce lag, and dramatically improve call quality.

Other services that are limited by network latency will be made viable. Services such as ONLIVE, an online multi-player, cloud gaming platform, are critically limited by latency . In general, low latency network speeds would allow users to perform tasks on remote servers that feel like they are occurring in real time, as communication speed will be dramatically improved. By eliminating previously insurmountable technological hurdles, future technology stemming from that developed specifically for HFT could revolutionize the technological landscape as we know it.

Perceptions of Social Groups

Defenders of High Frequency Trading claim that it has beneficial aspects. Some of the claimed benefits include lower transaction costs to all traders, added market liquidity, reduced spreads, and aid in price discovery. These proponents of HFT are lawyers, consultants, and clients whose interests are directly vested in the success of HFT. A head of T. Rowe Price, a mutual fund company that utilizes HFT, noted that

“You want to encourage innovation, and you want to reward companies that have invested in technology and ideas that make the markets more efficient. But we’re moving toward a two-tiered marketplace of the high-frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity."

Yet there exists a large and more diverse group of social players that are strongly opposed to HFT. Ranging from buyside traders and investment firms to day traders and value investors, these opponents assert that HFT leads to increased market volatility, leading to unnecessary fluctuations. In particular the critics of HFT say that it undermines the faith of ordinary investors in the market who do not have the technical skills and access to resources need for HFT. In the aftermath of the flash crash, the Securities and Exchange Commission is looking at regulating HFT, citing the potential destabilizing effects of HFT and how HFT can make profits at the expense of the market .

Controversy

““There is something unholy about them [HFT firms] ... They make a fortune whereas the public gets so whipsawed by this trading.” Guy P. Wyser-Pratte, a prominent wall street trader

During the flash crash HFT firms aggressively took liquidity (an asset's ability to be sold with out causing a change in the price) from the market, driving prices down further to the detriment of other traders . In addition to the destabilizing effects on the market, opponents of HFT say that the expensive, high tech data centers the HFT firms have built give them an unfair advantage by allowing them to leverage price changes before they are widely recognized by the market . However, the proponents of HFT counter that HFT is the natural evolution of the markets and that it actually lowers transaction costs for everyone . What ever the truth about high frequency trading is, it is clear that HFT firms have used developing technology to gain a unique advantage in the market place.

Conclusions

The merits of High Frequency Trading have and will be questioned as long as the practice continues. However, when qualifying HFT as a beneficial or harming technique, it is prudent to consider factors such as the ones described above. Some consequences of technological advancements are easily understood and visible in plain sight. Yet, there are a larger number of consequences that are ambiguous and need to meticulously assessed. Here we focused on the a few social and technological implications of HFT. Driven by the needs, perceptions, and motives of many social groups, technology is often bound by more than its physical limitations. As such, with the ability to drastically alter the social and technological landscape, technology must be carefully assessed and implemented accordingly.