Speed is everything in FX trading. The swiftness of data flows can make or break fortunes. However, the topic of HFT has set off heated discussions among regulators, financial experts, and academics.
High-frequency trading (HFT) can cause market volatility and provide institutional investors with an unfair edge over regular investors, who do not have the same access to resources and technology
However, advocates of the new technology see a variety of benefits.
High Sharpe Ratio
The advent of HFT has increased market liquidity and removed too-narrow bid-ask spreads. But when HFT fees were levied, bid-ask spreads expanded showing how important HFT is to preserving market efficiency.
Traders work on a razor’s edge by building up little capital, developing holdings for brief periods, and hardly ever keeping their portfolios overnight.
What that typically implies is that high-frequency traders have a considerably higher ‘Sharpe Ratio’ than conventional investors with long-term investment plans, which assesses the risk-reward ratio.
With high-frequency trading, people usually tend to rely heavily on speed, as one needs to execute trades within milliseconds. The catch is that with HFT, the focus is very myopic, as one’s interest lies in short-term gains at the expense of long-term stability or gains. Moreover, the high turnover rate for HFT can result in high transaction costs, which can erode profits and reduce returns.
Let’s assume John wants to invest in a company called Silver Corp. It has been years since John started investing, and he has spent time studying the market. John also believes that Silver Corp. has potential and will witness steady growth over the next five to seven years. On the other hand, Jane is a high-frequency trader and is more interested in short-term gains.
In the world of finance, every second counts. The microwave data service identifies a pattern that suggests that there will be a rise in the stock price of Silver Corp. As the stock price climbs rapidly in the next few seconds, Jane acts quickly and buys several shares, selling them in the next few seconds, pocketing a small profit.
Profiting primarily from short-term gains in HFT can cause one to lose sight of long-term investment plans in favor of short-term gains.
While Jane may be quick to cash in on short-term gains, she did not consider the prospect of long-term gains that John had carefully studied and analyzed. So, if John is right about the potential of Silver Corp, he will profit from a much larger return on his investment in the long run.
Jane will also have to bear transaction costs as she is buying and selling shares at a more rapid pace. Over time, these costs can add up and erode her profits.
HFT Amplifying Volatility
While every person is interested in HFT, there are risks associated with it.
High-frequency trading can be like adding fuel to a fire in the financial markets. While it may seem like a quick way to make a profit, the risks of amplifying market volatility cannot be ignored. It’s like a game of Jenga, where one wrong move can bring down the entire tower. Investors need to tread carefully and be equipped with the right tools and knowledge to handle the rapid price movements that HFT can create.
High-frequency trading (HFT) carries with it a potential risk of increasing market volatility. By executing trades at a fast speed, HFT algorithms can amplify price movements that can cause fluctuations in the market.
This may be disastrous for investors who are unprepared and can wreck their financial portfolios. Since HFT demands a sharp eye, quick reflexes, and the ability to react to changes in the market, anything less can prove to be a disaster.
Therefore, experts are vocalizing how HFT can impact the financial markets.
The advent of emerging technologies and electronic trading since the turn of the millennium has had unintended consequences. Specifically, leveraging these tools has been linked to an increase in market volatility, with investors sounding the alarm that market crashes can quickly spiral into large ones when amplified by new technologies. If investors react en masse to specific market signals, it can lead to a sell-off of portfolios and send shockwaves through the market.
According to a government probe, something similar happened when a large order sparked a sell-off that amplified and expedited market movements. On May 6, 2010, the Dow Jones Industrial Average (DJIA) experienced its largest intraday point drop in history, recording a drop of a whopping 1,000 points and losing 10% of its value in just a matter of 20 minutes before it eventually recovered.
Several European nations may ban high-frequency trading to curb volatility and avoid undesirable events like the 2010 US Flash Crash and the Knight Capital collapse. The aim is to avert negative consequences and prevent havoc in the financial market.
The Concentration of Wealth
HFT also gives some traders a leg up over other investors without the support of technological infrastructure. This often results in a concentration of wealth in the hands of a select few financially well-endowed players.
Experts have raised concerns that high-frequency trading gives large corporations an unfair advantage and tilts the playing field against small investors.
As a result, small investors are at a disadvantage in the market.
While it is easier for larger corporations to employ such tools in their infrastructure, small investors do not have the resources to compete with the speed and efficiency.
It may also be detrimental for investors that follow a long-term investment plan and take part in bulk purchasing or selling operations. This could make way for inequalities beyond what already exists within the financial systems. By making it challenging for regulators to keep an eye on and regulate the market, it raises the possibility of dishonest or manipulative trading practices.
An example would be the Flash Crash of 2010. While some HFT firms were able to profit from the rapid drop in the US stock market, other investors suffered losses. This led to a concentration of wealth among a few HFT players who took advantage of the market dislocation.
Eventually, it was disclosed that HFT algorithms, which were created to take advantage of slight price variations across various exchanges, were mostly responsible for the market turmoil. During the flash crash, these algorithms swiftly exited the market, accelerating the downward trend.
High-frequency trading (HFT) carries the issue of magnifying systemic risk. Given the breakneck pace at which high-frequency trading operates, even a single flawed algorithm can lead to losses worth millions within a few minutes.
HFT also carries significant dangers, like breaches and system failures. Due to its reliance on advanced technology, even a minor error can have devastating consequences, destabilizing financial markets and resulting in losses for traders and investors. A flaw in algorithmic HFT can trigger market volatility and cause a domino effect by sending ripples of chaos across other markets. Like the existing issues with the higher Sharpe ratio and concentration of wealth, the continual occurrence of atypical market fluctuations could lead to complications in the financial market.