A Concise High Frequency Trading Primer

Cato Institute’s Chairman Bob Levy helps demystify a most complex subject.

Here are a few thoughts on high frequency trading [HFT] – not a thorough analysis of the problems and solutions, but rather a brief outline to encourage further discussion.

What is HFT?

The modern version of HFT, as described by Malkiel and Leavitt in an April 11 Wall Street Journal op-ed, “involves the placement of high-speed computers in close proximity to stock-market servers to give some participants the ability to buy and sell stocks faster than the blink of an eye.” The favored participant purchases early access to information from either a public exchange or a so-called dark pool, which is essentially a private exchange established by investment banks. With privileged access, the HF trader can learn of a pending order before it is executed, and then earn a small profit by buying or selling ahead of the order. For example, a sell order exists at $100.00; an HF trader learns of a pending buy order at $100.02, which allows the HF trader to earn $.02 by first buying at $100.00 then selling at $100.02.

What are the pluses and minuses of HFT?

Benefits of HFT can include market efficiency, increased liquidity, and lower transactions costs. To illustrate: Assume orders have been placed to sell 5,000 shares of XYZ at $15.02 and 5,000 shares at $14.94. Assume further, a pending buy order for a minimum of 10,000 shares at $15.00. The HF trader, acting as market-maker, might buy 10,000 shares from the two sellers at an average price of $14.98 and re-sell the shares to the buyer for $15.00. The result would be a narrowed bid-asked spread, reduced trading costs, increased volume, and enhanced liquidity.

On the other hand, as Malkiel and Leavitt point out, HFT is a form of insider trading known as front-running whereby “optimally positioned traders can see trade orders from other investors before they are executed. They can execute a purchase just ahead of those orders and run the price up just a bit, pocketing the difference.” In addition, HFT has been blamed for increased market volatility.