HIGH FREQUENCY TRADING: THE PATH FORWARD FOR MARKET LIQUIDITY AND STABILITY
Floor traders and market makers once stood on trading floors in Chicago and New York ready to spot price discrepancies and trade for their own account when opportunities arose. They served to provide liquidity and make orderly markets. But human beings have limitations. We can only process and act on limited amounts of information. And the speed at which we can trade is relatively slow. Today’s securities and derivatives markets are complex and diverse. They are also fragmented and can be more volatile than before. Over the past decade, electronic and high frequency trading firms have replaced humans as the primary floor traders and market makers on securities and derivatives exchanges. High frequency trading firms now perform price discovery across a wide variety of markets, provide liquidity and help stabilise markets. Even if old traders in Chicago and New York miss the crowded trading floors, or are concerned about the risks often associated with the new electronic traders, market participants will continue to benefit from high frequency trading.
There is no formal definition of high frequency trading, but it can be described by a number of characteristics. According to the Securities and Exchange Commission in 2010, the characteristics most often associated with high frequency trading are: (i) the use of automated code, or algorithms, for generating, routing and executing orders; (ii) the use of colocation services, trading firms pay to locate their servers next to the exchange’s servers, with individual data feeds offered by exchanges and others to minimise network and other types of latencies; (iii) execution times consisting of microseconds or milliseconds to establish and liquidate positions; (iv) submitting numerous orders that are cancelled shortly after submission; and (v) ending the trading day in as close to a flat position as possible, with no significant, unhedged positions held overnight. While the hallmarks of high frequency trading bring new risks, the risks are outweighed by the benefits.
Jan-Mar 2017 Issue