High-Frequency Trading (HFT)

• Introduction
• Advantages
• Risks
• Regulation
• Future Trends

• High-quality trading refers to the practice of executing trades based on thorough analysis, sound investment principles, and a disciplined approach to risk management. It involves selecting assets with strong fundamentals, using reliable technical analysis, and adhering to a well-defined trading strategy. High-quality traders prioritize consistency, capital preservation, and long-term profitability over short-term gains, often focusing on minimizing losses and maximizing returns through prudent decision-making and continuous improvement.

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• HFT firms create artificial market depth and exploit informed insiders by constantly altering their strategies and orders. This adds liquidity and dynamic element to the market, benefiting market users. The strategy for doing this revolves around the theory that if you are on the same side as the informed insider, then you will make profits. But if you are on the opposite side, you will suffer losses. Therefore, HFT creates liquidity as it has been known to supply the other side of trades, i.e. if an informed trader is looking to buy a large number of shares, HFT will supply these shares. High-frequency trading carries several potential benefits for investors, including lower transaction costs. High-frequency trading is highly competitive and firms are constantly looking for ways to reduce latency and improve their strategies. This leads to lower prices for market users because HFT lowers the spread between the bid and ask price.

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• With hidden strategies and a high correlation between adverse selection and liquidity provision, HFT poses risks in attracting informed traders. Price manipulation can force informed HFTs to cancel strategies and make losses. Smart order routers can change destination based on real-time information, detrimental to HFT seeking specific order flow. HFT is popular in the financial world and preferred by practitioners. Different strategies, including online algorithms, react quickly to market changes. The signal can be generated by various events. Menkveld’s paper confirms the benefits of market-making with HFT participation.

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• Several regulations have been introduced post-‘flash-crash’ to address the high-frequency trading (HFT) issue. Controls have been implemented to limit the number of orders sent within a specific period, especially those significantly deviating from the market price. Examples include LULD, single stock pauses, and circuit breakers. LULD aims to prevent trades at unfavourable prices and protect non-HFT investors. While critics argue about its complexity, away-from-the-market orders will always be part of the execution goal. A report from FINRA and US stock exchanges in 2014 shows a reduction in off-quote executions but also a decrease in quoted spreads and order sizes. 2962 trading pauses in September 2013 question the sensitivity of the market structure changes. Firstly, existing regulations for HFT are largely related to ‘manual’ automated trading systems. Regulations are slow to keep pace with evolving HFT technology because they were established before the ninja-skills arms race. Algorithmic trading regulations were put in place post-crash.

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• Modern HFT faces increasing competition for liquidity globally. As competition grows, HFT profitability decreases. Profitable strategies like latency arbitrage and liquidity rebates will become less profitable due to increased competition. HFT strategies must evolve to remain profitable. Exploiting market inefficiencies is self-destructive as it erodes the opportunities being exploited. For example, increased HFT quotation activity has led to more liquidity rebate opportunities, but decreased average profit per share.

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