High-frequency Trading — Do regular investors stand a chance?

Mario Claudio Lattuga
Apr 29 · 27 min read
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I. INTRODUCTION

Distance ÷ time = Speed

II. REGULATIONS AND HFT

A. SEC Regulations and HFT

1. Regulation NMS

B. CFTC Rules and Regulations

High-frequency trading is not relegated to the securities markets; indeed, it is also prominent in the derivatives and cryptocurrency markets. For example, HFT firms have been under scrutiny for wash-trading, which has been outlawed since 1936 under CEA § 4c(a)(2).[31] Wash trading, or wash trades, are “fictitious, prearranged sales in which the same parties agree to a pair of offsetting trades for the same commodity, at no economic risk or net change in beneficial ownership.”[32] “Wash sales are ‘a powerful multipurpose tool that can be used . . . for significant frauds and market manipulations,’ and, as such, they “are considered harmful because they create illusory price movements in the markets.”[33]

III. THE BUSINESS OF HIGH-FREQUENCY TRADING

A. Speed is Everything

Stemming back to early 2010, many Wall Street traders (many of whom “would sell their grandmothers for a microsecond”[39]) suggested, “that their entire commercial existence depended on being faster than the rest of the stock market.”[40] The speed at which HFT platforms can transact can be measured by latency, or the time-lapse between the moment an order is issued and the moment that order is received. “[T]he average exchange-to-trader latency (the average time elapsed between the moment a message is sent by an exchange to the moment it is received by the firm) is 31 microseconds on average for messages pertaining to the SPDR S&P500 Exchange Traded Funds (so called SPY, traded on the NYSE).”[41] Low-latency is central to HFT efficacy because the primary advantage is speed itself, the ability to acquire information, and act upon that information, before others. Indeed, the “[s]peed of trading is important for high-frequency traders because it is key for the profitability of their strategies, in particular high-frequency market making, high-frequency arbitrage, and directional trading on very short-lived signals.”[42]

B. How HFTs Make Money

The speed of obtaining and executing information is the single most significant advantage of HFT.[43] Specifically, the ability to not only obtain information but act upon that information before anyone else is a huge advantage in today’s speculative markets.[44] Market-making is a method of capitalizing on the speed of information transfer and execution. Market makers quote both buy and sell prices resulting in market orders and are considered liquidity providers. Market making provides an opportunity to monetize (typically only a few cents per transaction) via the bid-ask spread. Due to a large number of transactions, monetization via high-frequency market making is enormous. Additionally, high-frequency arbitrage leverages speed to monetize on price disparities of different exchanges. HFT uses speed to “beat out” the official National Best Bid and Offer price updates, effectively creating its own version, and capitalizing on the latency.[45] Critics of HFT refer to arbitrage tactics as follows:

C. The Critics[55]

One of the first major public criticisms of HFT was levied in July 2009 by U.S. Senator Charles E. Schumer. Senator Schumer asked the Securities exchange Commission to prohibit “flash orders,” which allow a select group of traders to learn about buying and sell orders before the wider market. Senator Schumer noted that flashing information to some, and not others, “seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions.”[56] According to Senator Schumer, if allowed to continue, these practices will undermine the confidence of ordinary investors, and drive them away from our capital markets.”[57] Since then, there has been a multitude of arguments against HFT.

IV. CONCLUSION

The idea that one can ignore technological advances and intellectual advances driven by practitioners’ work or academics’ work is fallacious. You can wish for it, but it’s not gonna be. It’s very important to understand that — people in the markets understand it; the popular press does not — you can’t reverse technology and speed.[74]

The future is now. Despite what people believe, HFT is here to stay, and there is no slowing down innovation. Although many regulations touch upon HFT, perhaps it would be prudent to establish a framework for practitioners and innovators alike to utilize when contemplating new FinTech innovation using high-frequency trading. Innovation, however, necessitates something new or novel and, therefore, prescribing highly specific rules other than an outright ban may be impossible.

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Mario Claudio Lattuga

Written by

🚀 Founder, Compoundly 💼 Securities lawyer ☕️ Espresso enthusiast obsessed with FinTech. Pick my brain: https://calendly.com/mlattuga/15-minute-meeting

The Startup

Medium's largest active publication, followed by +720K people. Follow to join our community.

Mario Claudio Lattuga

Written by

🚀 Founder, Compoundly 💼 Securities lawyer ☕️ Espresso enthusiast obsessed with FinTech. Pick my brain: https://calendly.com/mlattuga/15-minute-meeting

The Startup

Medium's largest active publication, followed by +720K people. Follow to join our community.

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