The Rise of High-Frequency Trading: A Brief History

The concept of capitalism and free-market trading has been around for centuries. Since the world’s first stock exchange opened in Amsterdam in 1602, investors have sought ever more inventive ways of trading assets and making profits. The Dutch East India Company popularized the idea of owning shares of a company, paving the way for transferable assets that blossomed into the modern financial world we live in today.

Background

Prior to the computer age, trading technology consisted of carrier pigeons followed by telegraph cables. The founder of Thomson Reuters, Julius Reuters, actually combined the use of pigeons and telegraph machines to build what became a state-of-the-art news agency that revolutionized the speed at which information regarding news events were disseminated to the public.

It wasn’t until the 1980s that a real breakthrough in the logistics of stock trading was actually achieved. The advent of the computer allowed traders to access data on a level never before seen or thought possible. With an initial investment of $30 million from Merrill Lynch, Bloomberg designed and built the first computer system to use real-time market data to quote stock prices and relay information.

By the late 90s, the SEC ruled in favor of creating electronic stock exchanges. This laid the groundwork for a new type of trading: high-frequency trading or HFT. In just a couple of years, nearly 10% of all trades were done using HFT with a clearing time of just a few seconds. HFT is actually a thousand times faster than traditional human-to-human stock trading.

Understanding the World of High-Frequency Trading

High-frequency trading is an automated trading platform that executes buy and sell orders based on an algorithmic computer program. It’s a type of trading strategy implemented by large financial firms, such as hedge funds and investment banks, that allows them to trade millions of shares every day in transactions that often last less than a second.

Complex algorithms designed to analyze multiple financial markets and spot trends are the driving force behind HFT. These systems find arbitrage opportunities, pricing inefficiencies, and emerging trends using mathematical formulas that predict market movements and automatically execute trades. They move in and out of positions at an incredibly fast rate and almost never hold any position overnight, making these types of trading firms very liquid.

HFT strategies are purely algorithmic models that attempt to take advantage of mathematical opportunities and should not be confused with other investment strategies that utilize fundamental analysis and long-term growth planning. The method is risky because it deals with orders of magnitude higher than traditional investment models and therefore is not suitable for individual investors.

Many critics claim that HFT is an unfair practice that hurts smaller firms and individual investors because larger firms are able to take advantage of situations to which others do not have access. Proponents, however, point out that HFT increases liquidity in the financial markets and can lower bid-ask spreads for all investors.

High-Frequency Trading Since 2000

The advent of HFT at the turn of the millennium saw trades taking just a couple of seconds to clear and encompassing around 10% of all trade executions. Within just five years, HFT made up 35% of all stock transactions. From 2005 to 2009, high-frequency trading volume increased by 164%. By 2010, however, the first warning signs that this type of trading could be dangerous finally emerged.

HFT was officially responsible for more than half of all trade executions by 2010. In May that same year, computer-based trading sold off more than $4.1 billion in equity holdings, triggering a flash crash in which the Dow plunged 1,000 points in a single day. The initial sell-off triggered a wave of other sell-offs based on the designed algorithms, causing the extreme drop in values. While stocks quickly recovered from the error, the SEC became fully aware of the dangers associated with computer-driven trading platforms.

Trading times reached nanosecond speed in 2011 when a company named Fixnetix developed a microchip capable of processing trades at never-before-seen speeds. By 2012, nearly 70% of trades were accomplished using HFT. The same year brought a wave of HFT investments as well, including a transatlantic cable for the sole purpose of shaving 0.006 seconds off of trading time and a social media-based trading platform that executes trades based on social trending. The concept of micro-trends stemming from popular social media topics during the day helped amplify HFT successes.

As social media proliferated throughout the financial industry, a false tweet in 2013 triggered a brief panic sell-off, wiping 143 points off the Dow in a matter of minutes. The sheer speed and volume of HFT was once again seen when the Fed announced its plan to taper off of QE. Over $600 million were traded in milliseconds before the news hit the mainstream media.

What the Future Holds for HFT

In recent years, HFT has been the subject of regulatory talks, with Italy being the first to officially implement an HFT trading fee in order to discourage that type of investment activity. Economists and other financial leaders have been discussing new ways to regulate HFT trading as well, and it seems likely that new laws will be passed in order to curb dangerous trading activity that has systemic risks.

It hasn’t prevented the HFT industry from growing, though.

Since the flash crash in 2010, HFT platforms have been revamped in order to assess future risks and streamline the trading process. Stock analysis has given way to a more mathematical and technological approach whereby a single company’s balance sheet and earnings become meaningless next to algorithms designed to spot trading trends and pricing inefficiencies.

The Bottom Line

The real question moving forward is whether traditional investment models can still be used alongside HFT. If HFT prevents long-term investment planning, then it could be a danger to the entire modern financial system. So far though, aside from momentary lapses in technology, HFT hasn’t truly hurt long-term investment strategies and might even have helped introduce additional liquidity to the marketplace.