Over the past few years, high-speed or high-frequency trading — known as H.F.T. — was the biggest new thing to hit Wall Street trading, and in the minds of many, the most disruptive. On any given day, this lightning-quick, computer-driven form of trading accounts for half of all of the business transacted on the nation’s stock markets.
Critics say H.F.T. has contributed to the hair-raising flash crashes and computer hiccups that seem to roil the markets with alarming frequency.
H.F.T. first became a significant part of the Wall Street scene in the 1980s, when it was blamed for exacerbating the market plunges in October 1987. Since then, the computers involved have grown vastly more powerful and the algorithms that guide their trading vastly more sophisticated.
For years, H.F.T. firms have operated in the shadows, often far from Wall Street, trading stocks at warp speed and reaping billions while criticism rose that they were damaging markets and hurting ordinary investors. More recently, they have been stepping into the light to buff their image with regulators, the public and other investors.
At the same time, figures suggest that the practice may be cooling down a bit. Profits from high-speed trading in American stocks were on track to be, at most, $1.25 billion in 2012, down 35 percent from 2011 and 74 percent lower than the peak of about $4.9 billion in 2009, according to estimates from the brokerage firm Rosenblatt Securities. And the percentage of stock trades handled by firms that specialize in H.F.T. fell to about 51 percent in 2012 from 60 percent in 2009.
Drops in overall trading volume have made it harder to make profits for traders who quickly buy and sell shares offered by slower investors. In addition, traditional investors like mutual funds have adopted the high-speed industry’s automated strategies while the technological costs of shaving further milliseconds off trade times has become a bigger drain on many companies.
Meanwhile, the firms are trying to stave off the regulators who are proposing to curb their activities. To make their case, the firms have formed their first industry trade group, hired former Securities and Exchange Commission staff members and spent nearly $2 million in the last few years on Washington lobbying and contributions to lawmakers. Some even want to be called “automated trading professionals” rather than high-frequency traders.
Good Thing for Ordinary Investors, British Report Says
In October 2012, a new study concluded that the rise of high-speed trading firms has generally been a good thing for ordinary investors. The two-year British government study, however, found that the increasing prevalence of computerized trading may lead to isolated incidents of instability in the financial markets.
The report, released on Oct. 22, is the product of the most comprehensive effort to date to understand the computerized trading firms that have come to dominate the financial markets and generate anxiety among regulators and investors.
But the committee concluded that regulators had failed to gather enough data or build the expertise needed to allay a widespread assumption among professional investors that faster traders have an advantage and profit at the expense of ordinary investors.
The committee’s conclusions were consistent with a number of academic studies that have found that competition between H.F.T. firms has made it easier and cheaper for ordinary investors to buy or sell stock whenever they want.
New Regulations, Outside the U.S.
Industry leaders and regulators in several countries including Canada, Australia and Germany have adopted or proposed a wide range of limits on high-speed trading and other technological developments that have come to define United States markets. The flurry of international activity is particularly striking because regulators have been slow to act in the United States, where trading firms and investors have been hardest hit by a series of market disruptions, including the flash crash of 2010 and the runaway trading in August 2012 by Knight Capital that cost it $440 million in just hours.
In an acknowledgement of how far behind market players it has fallen, the S.E.C. in October 2012 prepared to install a program designed by a high-frequency trading company that will give the agency a better real-time look into market transactions.
The program, called “Midas” by the S.E.C., was part of a broader effort at the agency to monitor the proliferation of new technologies and to crack down on practices that have given sophisticated traders an advantage over ordinary investors. But the S.E.C. will still not have the complete picture. It will not, for instance, have information on the trades executed in so-called dark pools, trading venues that do not have to follow the same reporting rules as the public exchanges.
For most of Wall Street’s history, stock trading was fairly straightforward: buyers and sellers gathered on exchange floors and dickered until they struck a deal. Then, in 1998, the S.E.C. authorized electronic exchanges to compete with marketplaces like the New York Stock Exchange. The intent was to open markets to anyone with a desktop computer and a fresh idea.
But as new marketplaces have emerged, PCs have been unable to compete with Wall Street’s computers. Powerful algorithms — “algos,” in industry parlance — execute millions of orders a second and scan dozens of public and private marketplaces simultaneously. They can spot trends before other investors can blink, changing orders and strategies within milliseconds.
High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there.
High-frequency traders also benefit from competition among the various exchanges, which pay small fees that are often collected by the biggest and most active traders — typically a quarter of a cent a share to whoever arrives first. Those small payments, spread over millions of shares, help high-speed investors profit simply by trading enormous numbers of shares, even if they buy or sell at a modest loss.
Flash Crash: Computers Gone Wild
The S.E.C. started to think these firms needed tighter controls in early 2009 when analysts for the first time began to point to the sector’s billions in profit, and critics wondered whether their technological firepower gave them an unfair advantage.
The scrutiny intensified after May 6, 2010, when shortly before 3 o’clock, the stock market plummeted. In just 15 minutes, the Dow tumbled 600 points — bringing its loss for the day to nearly 1,000. Then, just as fast, and just as inexplicably, it sprang back nearly 600 points, like a bungee jumper. It was one of the most harrowing moments in Wall Street history. And for many people outside financial circles, it was the first clue as to just how much new technology was changing the nation’s financial markets.
Since the 2010 flash crash, mini flash crashes have occurred with surprising regularity in a wide range of individual stocks. In the spring of 2012, a computer glitch scuttled the initial public offering of one of the nation’s largest electronic exchanges, BATS, and computer problems at the Nasdaq stock market dogged the I.P.O. of Facebook.
And in August 2012, Knight Capital, a brokerage firm at the center of the nation’s stock market for almost a decade, nearly collapsed after it ran up more than $400 million of losses in minutes, because of errant technology. It was just the latest high-profile case of Wall Street computers gone wild.
Regulators are playing catch-up. In the United States and Europe, they have fined traders for using computers to gain advantage over slower investors by illegally manipulating prices, and they suspect other market abuse could be going on.
Regulators are also weighing new rules for high-speed trading, with an international regulatory body to make recommendations in the fall of 2011.
After the flash crash, exchanges introduced circuit breakers to halt trading after violent moves.
In the United States, the Securities and Exchange Commission looked into the new market structure for almost two years. In July 2011, it approved a “large trader” rule, requiring firms that do a lot of business, including high-speed traders, to offer more information about their activities in case regulators need to trace their trades.
One of the most controversial actions has been the European Commission’s proposal for a financial transaction tax on speculators, which would hit high-frequency firms and curtail volumes.
And the S.E.C. has proposed what would be an even more high-powered monitoring system called a consolidated audit trail that would gather data on trades in real time from all United States exchanges, and be a powerful tool in helping regulators piece together events in case of another flash crash.
In late 2011 regulators in the United States and overseas were cracking down on H.F.T., worried that as it spreads around the globe it is making market swings worse.
Overseas Regulations Advance
The German government in September 2012 advanced legislation that would, among other things, force high-speed trading firms to register with the governmentand limit their ability to rapidly place and cancel orders, one of the central strategies used by the firms to take advantage of small changes in the price of stocks. A few hours later, a European Union committee agreed on similar but broader rules that would apply to the entire Continent if they win approval from the union’s governing bodies.
In Australia, the top securities regulator recently stated its intention of bringing computer-driven trading firms under stricter supervision and forcing them to conduct stress testing, to protect the country’s markets “against the type of disruption we have seen recently in other markets.”
The broadest and fastest reforms have come out of Canada, where in early 2012 regulators began increasing the fees charged to firms that flood the market with orders. The research and trading firm ITG found that the change had already made trading more efficient by reducing the crush of data burdening the market’s computer systems.
Canadian trading desks face new rules that will come into effect on Oct. 15 and curtail the growth of the sophisticated trading venues known as dark pools that have proliferated in the United States. While the regulation has been hotly debated, many Canadian bankers and investors have said they don’t want to go any further down the road that has taken the United States from having one major exchange a decade ago to having 13 official exchanges and dozens of dark pools today.
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