High-frequency trading (HFT) is a market-skewing, artificial form of speculation that places undo pressure on already fragile markets, which, by doing so, increases the risk of another flash crash or something much worse. HFT accounts for over 50% of all trading volumes, further distancing individual investors from the market and eliminating virtually any link between valuation and market price.
The problem with all of the above is that no one seems to be able to specifically define what HFT actually is.
According to Joseph Saluzzi, co-author of the book Broken Markets, the defining characteristic of HFT is speed. Saluzzi says the rules of the game are simple: "If your computer is faster than the other computer, you can win the trade."
By "fast," Saluzzi means blazing. HFT shops are pushing nanosecond response times. For comparison's sake, the blink of an eye takes 200,000,000 nanoseconds.
These trades are all based on picking up the next penny of a stock's move. The programs look for any indication of direction—be it order imbalance, momentum tells, or whatever else can be jammed into an algorithm—and jumps in front of the trade. The goal is to buy a few thousand shares ahead of a tiny move, and then sell when the move arrives. Repeat the process millions of times a year and it adds up to real profits for HFT firms.
The high-frequency trades run amok because there is no longer a market maker (read: human) in the middle of the trading process. The function of matching every buyer with a seller is fully automated, eliminating what Saluzzi calls a "shock absorber" for stocks. As a result, too many program trades can create vacuums where prices lurch beyond where they otherwise might be, as the HFT merrily picks off market orders made by actual people.
High-frequency trading isn't a good thing or a bad thing; it just is. Advocates claim the huge volumes created by HFT are providing liquidity to the markets. Saluzzi thinks the computers eliminated the price discovery system, divorcing markets from what they're actually supposed to be.
Saluzzi and his partner Sal Arnuk offer several fixes to the current system in Broken Markets:
The SEC can approve proposals made in the wake of the 2010 "flash crash."
Investigations of Dark Pools, and what Saluzzi calls "eye in the sky" monitoring, were promised after HFT triggered a nearly 1,000 point one-day drop in the Dow Jones Industrial Average on May 6, 2010. None of these have been implemented.
Stocks used to have spreads between bid and ask, creating a profit for market makers who would connect buyers and sellers. The lack of a spread in the current system makes it possible to scalp pennies on every trade—the bread and butter of HFT.
Impose a Speed Limit
Saluzzi suggests reducing the speed of placing and cancelling orders to a maximum of 50-milliseconds, eliminating the arms race of creating ever-faster machines and creating a level playing field.