Impact of HFT on Private Investors

Recent years have seen the rise of an incredible technology that has been the chief architect of shrinking manpower on trading desks. The technology has worked so well that it has brought about a fundamental shift in the sales and trading industry and even inspired a book by Michael Lewis (“Flash Boys”). From an industry that employed hundreds of traders per bank sitting on trading floors the size of football fields, there are now less than 5 people on particular desks at times in those same institutions. While business graduates were all the rage back in the day, the impact of this technology has brought about a shift in demand towards graduates more oriented towards the more quantitative fields such as mathematics, computer science and physics. All of this has been the impact of high frequency trading: a specialized trading system that is computerized and requires minimal to zero human effort. It is essentially a platform that can make large amounts of transactions per second by employing powerful computers. These computers run multiple, sophisticated algorithms in various markets, assess arbitrage opportunities and execute these orders when the opportunity arises. However, the growth of this technology has somewhat diminished the utility that the private investor gains from trading in the stock markets. Even at optimum human speeds, these investors are simply not fast enough to identify and act upon the opportunities that HFT provides.

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This means that at some point, private investors may be deprived of a fair price that they would ordinarily be able to get. When an investor places an order, it travels over a high-speed cable to different markets and arrives at varying times. However, even though the time differential is absolutely miniscule – sometimes even microseconds – the HFT technology can jump in ahead to see the action that the investor sent. If the investor sent a buy order for 19 share units of XYZ stock, the HFT buys those 19 units ahead of the investor and sells those units back to the investor at a higher price, thus enabling a quick, easy profit. While traditional private investors prefer fundamental or technical analysis to justify their trades, there is no rationale required in the HFT trade. It is simply a technology that can be said to be “proactively reactive” i.e. jumping in ahead of you to see what you are doing and mirror it.

The HFT technology has proliferated to such an extent that billions of dollars are now made each year by these traders. But the investment into the technology continues to grow. While these strategies have no fundamental rationale, companies are spending billions in capital expenditure on honing the technology to become faster and more versatile, essentially creating a new industry within the sales and trading industry. While some proponents of HFT have argued that the strategy only affects short term traders and speculators, there is still a compelling case for how it impacts long term buy and hold traders adversely as well. As the stability of the market gets damaged, that has a psychological impact on investors, who are then far more conservative when it comes to making trades. In addition to that, while the impacts happen on a more granular level for long term traders, they are still missing out on gains that they would otherwise be able to get in the absence of HFT.

As more and more companies invest into the technology attempting to reap the benefits, it is clear that there must be a balance of human interaction versus technological dominance. In an arena where any arbitrage or profitable opportunity is quickly siphoned off, it does not bode well for the individual investor who would then look to exit the market to pursue other positive NPV activities. Governments, HFT entrepreneurs and market makers alike will have to look to work together to avoid this occurrence.

 

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