High-Frequency Trading 101: The Good, the Bad and the Truth

Adam Sussman, director of research at TABB Group and author of many reports on market structure, joined us this morning to help clear up some of the confusion about what high-frequency trading is (and isn't).

So here's a little primer/cheat sheet that hopefully will clear up some confusion and misconceptions about these super fast, computer driven trades:

• It's a good thing: High-frequency trading provides liquidity and helps ensure the "certainty of orders," Sussman says, by giving investors rapid response to their buys and sells. In this regard, computer-driven high-frequency trading makes for more efficient markets vs. the old days, when human "specialists" could sit on a order for seconds or even minutes before executing. (Eric Falkenstein delves deeper into this topic on Clusterstock.com)
• It's huge: TABB estimates high-frequency traders are involved in 73% of all U.S. equity volume today, up from 35% in 2006. The research firm estimates high-frequency traders have generated $21 billion in annual revenue over the past 12 months. (Notably, high-frequency trading isn't new it's just getting more popular as the cost of computing has come down and barriers to entry fall.)
• There's a difference between high-frequency trading and "flash orders": This is key because many recent reports have wrongly conflated the two. "Flash orders" - provided by electronic exchanges such as BATS and Nasdaq OMX - give the recipients an advantage by providing them a look a buy and sell orders a fraction of a second before they are made available to everyone. Flash orders slow down execution and increase uncertainty, Sussman says. "The problem with flash orders is it introduces the same level of uncertainty as sending orders to a human being," he says. "It's an intentional slowing of your order" -- even if just by milliseconds.

As discussed in the accompanying video, "flash orders" emerged from SEC Regulation NMS. Passed in 2007, the rule was designed to "facilitate price discovery" by requiring exchanges to share their order flow with other electronic markets. But since the exchanges want to keep orders in house, they are allowed to provide "flash orders" to their preferred clients before sending them out to competitors.

New York Senator Chuck Schumer has asked the S.E.C. to ban the practice of "flash orders", which does create an unlevel playing field but should not be confused with the broader practice of high-frequency trading.