An Objective Look At High-Frequency Trading And Dark Pools
From the 2010 Flash Crash to Michael Lewis’ 2014 book Flash Boys, High Frequency Trading (HFT) has gained significant notoriety. Though the actual volume of HFT leveled off around 2009, HFT continues to be a highly-scrutinized and much-debated topic when it comes to trading and transparency in today’s global financial marketplace. So what exactly is HFT? How do traders use structural vulnerabilities to ensure the quickest trade delivery? What role do dark pools play?
In conjunction with the five-year anniversary of the Flash Crash, PwC is out today with a new report, “An objective look at high-frequency trading and dark pools,” which answers these questions, puts to rest several myths about HFT and lays out a general look at policy changes to-date as well as proposed changes. PwC’s report also provides an overview of strategies that traders use in HFT and its implications on the market overall.
High-frequency trading has been in the news a lot over the past few years. The “Flash Crash” of 2010—when the Dow Jones Industrial Average experienced one of its biggest one-day point declines (of almost 1,000 points) in its history—was followed by the 2014 publication of Michael Lewis’s bestselling nonfiction book, Flash Boys. As a corollary to this story, and equally controversial, dark pools have been sought by investors who are looking to avoid interacting with aggressive liquidity, usually from high-frequency trading firms. What’s the big deal?
The two most active stock index instruments traded in electronic futures and equity markets, the E-Mini S&P 500 futures contracts (E-Mini) and the S&P 500 SPDR exchange traded fund (SPY), suffered steep declines during the May 6, 2010 “Flash Crash.” The E-Mini dropped to $2.65 billion from nearly $6 billion—55%—and the SPY fell to $220 million from $275 million, a 20% decline.1
Just the facts
Prior to the 1990s, the manner in which stocks were traded in the US was relatively simple: an investor made a decision to buy or sell and conveyed this information to a broker, who then routed the order to an exchange, where bids and offers were matched and a trade was executed. All parties had access to the same information about a stock’s bid-ask spread.
Today’s trading is a lot more complex and frequently involves little human intervention. Most importantly, trading is done in microseconds—less than a blink of an eye. The dramatic increase in the number of available trading platforms, along with significant technological advancements, makes the process by which orders are handled, routed, and executed much more complex. Brokerdealers use algorithms to route different portions of an order to different venues in various sequences, taking into account many factors (including minimization of market impact, minimization of information leakage, immediacy of execution, and cost of execution).
With these innovations came changes to the accessibility of information among all market participants. Requests for more liquidity in the markets and the Securities and Exchange Commission’s (SEC) adoption of a number of regulations aimed at modernizing the market structure—including decimalization, regulation of alternative trading systems, and Regulation National Market System (Reg NMS)—further set the stage for high-frequency trading (HFT) and dark pools.
What is high-frequency trading?
There’s no definition for HFT in the securities laws or regulations. So what is it? HFT is not a trading strategy as such but applies the latest technological advances in market access, market data access, and order routing to maximize the returns of established trading strategies.
Attributes of high-frequency trading often include the following:
- use of extraordinarily high-speed programs for generating, routing, and executing orders
- use of “co-location” services and individual data feeds offered by exchanges and others to minimize network and other types of latencies
— What is “co-location?” A co-location service is an arrangement with trading centers (or third parties that host trading centers’ matching engines) to rent space to market participants so that these participants can physically locate their servers in close proximity to a trading center’s matching engine. This close proximity saves microseconds of latency.
- very short time frames for establishing and liquidating positions
- submission of numerous orders that are canceled shortly thereafter
- ending the trading day in as close to a flat position as possible
HFT is not a homogeneous practice but instead includes a wide variety of strategies:
- Market making: Passive market making primarily involves the submission of non-marketable resting orders that offer (or “make”) liquidity to the marketplace at specified prices and receive a liquidity rebate if they are executed. Incoming orders that execute against (or “take”) the liquidity of resting orders are charged an access fee. The strategy is to make money on the bid-ask spread; HFTs place bets on both sides of the trade by placing a limit order to sell slightly above the current market price or to buy slightly below the current market price, thereby profiting from the difference. Most, but not all, market makers use high-frequency trading or other form of algorithmic trading.
- Arbitrage: An arbitrage strategy seeks to exploit momentary inconsistencies in rates, prices, and other conditions among exchanges or asset classes. For example, the strategy may seek to identify discrepancies between the price of an ETF and the underlying basket of stocks and buy (sell) the ETF and simultaneously sell (buy) the underlying basket to capture the price difference.
- Structural: Some proprietary firms’ strategies may exploit structural vulnerabilities in the market or in certain market participants. For example, by obtaining the fastest delivery of market data through co-location arrangements and individual trading center data feeds, proprietary firms theoretically could profit by identifying market participants who are offering executions at stale prices.
- Directional: Neither passive market making nor arbitrage strategies generally involve a proprietary firm taking a significant, unhedged position based on an anticipation of an intra-day price movement of a particular direction. There may be, however, a wide variety of short-term strategies that anticipate such a movement in prices. Some “directional” strategies may be as straightforward as concluding that a stock price temporarily has moved away from its “fundamental value” and establishing a position in anticipation that the price will return to such value. These speculative strategies may contribute to the quality of price discovery in a stock. Two particular types of directional strategies, however, have been identified as potentially presenting problems to market integrity: order anticipation and momentum ignition.
See full PDF below.