Explain to me: High-frequency trading

Dark pools. Collateral-easing. Exchange-traded funds. FICO. Securitize. Liquidity… ah, the list goes on.

The ratio of people who understand how Wall Street works to people who don’t understand how Wall Street works is probably something like 1:1,000. Higher, maybe? Probably.

That’s why I worship news sites like Planet Money and projects like The Crisis of Credit.

A good financial reporter is someone who can break down complex ideas and make them compelling for people who would rather click on the photo of Snooki’s newborn child.

So, I’ll be using The Street Beat blog to practice this skill. This week’s “Explain to me” will be about high-frequency trading.

When I first heard the term high-frequency trading, I envisioned a bunch of Wall Street suits and ties running frantically around a trading floor waving papers and yelling obscenities, not wanting to miss out on any action or waste a single second.

Turns out, that’s not really the case. The scene, as shown in this YouTube clip of the New York Stock Exchange trading floor, is much calmer and quieter, with traders sitting on stools and intently staring at their computer screens.

In the U.S., almost 75 percent of equity trades happen through computers that use high-frequency trading programs.

By definition, high-frequency trading (HFT) is when traders use computers to process a high number of orders very quickly.

HFT was put in the spotlight on May 6, 2010 on the day known as the 2010 Flash Crash. Around 3 in the afternoon, the Dow Jones Industrial Average was about 300 points down. Then in the next five minutes, the market dropped an additional 600 points. Twenty minutes later, it went back up about 600 points. This type of volatility is rare in the stock market and caused some people to lose a lot of money. While the exact causes of the Flash Crash still aren’t known, the U.S. Securities and Exchange Commission (SEC) said HFT was partly to blame.

Here’s a Planet Money piece about HFT that was published a month after the Flash Crash. As the host explains, HFT is “based on algorithms that direct computers to scour the market for tiny opportunity– make one cent here, half a cent there. The computers do that millions of times an hour at such high speeds that in the end, it adds up to real money.”

But with speed comes risk. Two years later, we’re continuing to see more examples of how HFT can go wrong. The most recent example is U.S. broker Knight Capital Group.

In early August, because of a “glitch in the automation process,” the firm lost $440 million. As explained by CNNMoney, “In less than an hour, Knight Capital’s computers executed a series of automatic orders that were supposed to be spread out over a period of days.” The money lost was almost four times the company’s 2011 profit.

The article goes on to say “Stock markets have become increasingly vulnerable to bugs over the last decade thanks to financial firms’ growing reliance on high-speed computerized trading. Because the trading is automated, there’s nobody to apply the brakes if things go wrong.”

So how valuable is HFT anyway? Thomas Peterffy, who helped pioneer the use of computers for stock trading, tells Planet Money that computer automation has made buying and selling stocks much cheaper. But the risks associated with how fast the trades move are hurting the system, he adds.

“We are competing at milliseconds,” he says. “And whether you can shave three milliseconds of an order, has absolutely no social value.”

Peterffy says there needs to be more regulation of HFT. Earlier this year, a former lawyer from the SEC told the Huffington Post “It’s inconceivable that they can regulate [high-frequency trading] systems; they’re all idiosyncratic; they’re all different. The SEC is starved for cash, starved for talent. A small-size hedge fund can outperform the SEC.”

If the SEC has no effective way to regulate HFT, that means incidents like the Flash Crash or what happened to Knight Capital could easily happen again and no one would be able to explain why.

If you’re interested in learning more about regulation of HFT, here’s a great New York Times “Room for Debate.”

So, those are the basics of HFT.

On a final note, if you’re a journalist or avid news consumer reading this, maybe you saw some similarities between HFT and reporting breaking news stories? I’ll just say, I agree with Peterffy about there being “absolutely no social value” in shaving off a few milliseconds.

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Author:Anika Anand

Anika Anand is a student at the City University of New York Graduate School of Journalism specializing in business and economics reporting. Check out her portfolio at anikaanand.com.

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