The Elusive Definition of High Frequency Trading Pt. II

Why all the Fuss?

High frequency trading has gotten a lot of media attention over the past few days, much of which most of which has been negative.  This is due to a couple of factors:

  1. The down market has created disgruntled (and vocal) concerned citizens wary of the finance industry.  That resentment and distrust has surfaced in the mainstream media in which bailout money, AIG, Lehman Brothers and the finance industry are lumped together and demonized as an amorphous, sinister entity out to trample the rights of the common person.  High frequency, in the eyes of the layman, is representative of this.
  2. People don’t really understand high frequency trading.  In many instances, it’s wrongfully lumped together with practices like flash orders or short selling.  The real danger with this lack of understanding is that it leads to uninformed regulation. This perpetuates the lopsidedness of the market and results in regulations created to control a few being extended to many. One size cannot fit all in a regulatory landscape.

What is the Next Hurdle?

The market crash has created a political environment where heavily lobbied decisions that may not in the best interest of market participants are being forced on the industry.  Under political pressure and widespread scrutiny from the media, the SEC doesn’t have the luxury of time to do extensive due diligence before legislating.

During the the crash the SEC tried to prevent stocks from falling with regulations like banning short selling, but the spreads only got larger and because of the hysteria, there is now political pressure to bring back some version of the rule which was studied for years before finally being repealed.  The data and statistics show that it will probably have a negative effect but there is a hue and cry to do something, so something must be done. For those who argue that current market structure does not work need a lesson in history, to start of with even with all the turmoil that was happening in 08 stocks still have tight spreads and liquidity was available across the broad spectrum from small cap to large cap. What more of a test can you ask for than what happened in 08 ?  Whereas back on Black Monday in 87 and in the early 90s, for Nasdaq listed stocks the market would completely dry up the bid/ask spreads become too wide to be usable in really bad market conditions.

The current climate, lack of knowledge about what caused the market crash and the need to do something combined with a lack of understanding of HFT has caused it to become a the target of blame for anything wrong.

What Does the Future Hold?

Matching engines, a major part of the trade execution process, are currently limited by the communications between servers they run on. Technology-forward liquidity venues like NYSE are working on things like broad in-memory trading.  In as little as 3-4 years, everything will sit in one big memory box, removing the physical drag of communication between computers.  Latency’s only limitation will become that pesky speed of light and it will make today’s trading pace look like a horse and cart race.

The cost of entry and ability for smaller players to be able to participate will continue to increase as more competing vendors force prices down, for example the executing broker Lime Brokerage is known for providing very low latency execution.

Technologies like open source are also enjoying extensive adoption at investment firms of all sizes. Access to source code means infinite flexibility without being beholden to proprietary vendor release schedules and cost. Financial firms that have no internal software development can take advantage of the existing functionality in an open source platform, and innovate where they need to. Some of the world’s largest banks are using open source at every point in the investment cycle including Linux platforms, CEP engines like Esper, front-end trading platforms like Marketcetera and feed handlers like the Collaborative Software Initiative.

What Does it all Mean?

Several years ago, the barrier to entry into the world of high frequency trading was patently higher than it is today.  There were numerous startup costs, including expensive hardware, implementation, service and maintenance.  Only the bulge bracket sell side and buy side firms could play in this game. Today, if you are a small buy-side shop with two traders and a developer you could be up and trading automated strategies productively in three to four months.

There is a also a cultural change starting whereby technical people are collaborating virtually and sharing information about the standardized infrastructure… a great example is QuickFIX.  Trading firms are able to spend more on intellectual capital – the strategies and the algorithms that will gain them competitive advantage – instead of saddling themselves with large capital investments in expensive and restrictive infrastructure. The level playing field created by this perfect storm of technology and market pressure will bring with it thousands of new entrants into the high frequency trading game.

2 thoughts on “The Elusive Definition of High Frequency Trading Pt. II

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