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High Frequency Trading: Do Regulators Need to Control this Tool of Informationally Efficient Markets?

High Frequency Trading: Do Regulators Need to Control this Tool of Informationally Efficient Markets?

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Published by Cato Institute
High Frequency Trading (HFT) is a form of algorithmic trading where firms use high-speed market data and analytics to look for short term supply and demand trading opportunities that often are the product of predictable behavioral or mechanical characteristics of financial markets. Often called "equity market making," HFT firms usually hold their positions for less than a minute while perpetually looking for opportunities to buy and sell. These transactions happen thousands of times a day, take microseconds, and often net less than a penny in profit per share traded.

Concerns have been raised in recent years about the potential market risks associated with HFT and algorithmic trading in general. Some opponents have argued that these practices create risk and require aggressive regulation. Purported risks to the stability and integrity of financial markets created by HFT include the creation of a two-tiered market system as a result of asymmetric information, potential volatility, "noise" and informational distortions, out-of-control algorithms, and "flash crashes." However, many of these concerns are neither new nor exclusively related to HFT.

HFT is, quite simply, a contemporary tool that facilitates informational market efficiency and, as such, is capable of being regulated by the market and market participants—indeed, there is significant evidence to indicate HFT activity is already being regulated by the market. At the same time, HFT improves market efficiency by lowering the costs to investors, controlling volatility, and improving liquidity. Many of the concerns raised by those calling for increased regulation predate the emergence of HFT, and thus those concerns are not particular to HFT. There are, however, opportunities for regulators, HFT firms, and exchanges to continue to work together to monitor and develop internal and external "circuit breakers" and consolidated audit trails to ensure continued market stability and integrity.
High Frequency Trading (HFT) is a form of algorithmic trading where firms use high-speed market data and analytics to look for short term supply and demand trading opportunities that often are the product of predictable behavioral or mechanical characteristics of financial markets. Often called "equity market making," HFT firms usually hold their positions for less than a minute while perpetually looking for opportunities to buy and sell. These transactions happen thousands of times a day, take microseconds, and often net less than a penny in profit per share traded.

Concerns have been raised in recent years about the potential market risks associated with HFT and algorithmic trading in general. Some opponents have argued that these practices create risk and require aggressive regulation. Purported risks to the stability and integrity of financial markets created by HFT include the creation of a two-tiered market system as a result of asymmetric information, potential volatility, "noise" and informational distortions, out-of-control algorithms, and "flash crashes." However, many of these concerns are neither new nor exclusively related to HFT.

HFT is, quite simply, a contemporary tool that facilitates informational market efficiency and, as such, is capable of being regulated by the market and market participants—indeed, there is significant evidence to indicate HFT activity is already being regulated by the market. At the same time, HFT improves market efficiency by lowering the costs to investors, controlling volatility, and improving liquidity. Many of the concerns raised by those calling for increased regulation predate the emergence of HFT, and thus those concerns are not particular to HFT. There are, however, opportunities for regulators, HFT firms, and exchanges to continue to work together to monitor and develop internal and external "circuit breakers" and consolidated audit trails to ensure continued market stability and integrity.

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Published by: Cato Institute on Jul 16, 2013
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Executive Summary 
High Frequency Trading (HFT) is a form of algorithmic trading where firms use high-speedmarket data and analytics to look for short-term supply and demand trading opportunitiesthat often are the product of predictable behav-ioral or mechanical characteristics of financialmarkets. Often called “equity market making,”HFT firms usually hold their positions for lessthan a minute while perpetually looking for op-portunities to buy and sell.
 
These transactionshappen thousands of times a day, take micro-seconds, and often net less than a penny in prof-it per share traded.Concerns have been raised in recent yearsabout the potential market risks associated withHFT and algorithmic trading in general. Someopponents have argued that these practicescreate risk and require aggressive regulation.Purported risks to the stability and integrity of financial markets created by HFT include thecreation of a two-tiered market system as a re-sult of asymmetric information, potential vola-tility, “noise” and informational distortions,out-of-control algorithms, and “flash crashes.”However, many of these concerns are neithernew nor exclusively related to HFT.HFT is, quite simply, a contemporary toolthat facilitates informational market efficiency and, as such, is capable of being regulated by themarket and market participants—indeed, thereis significant evidence to indicate HFT activity is already being regulated by the market. At thesame time, HFT improves market efficiency by lowering the costs to investors, controlling vola-tility, and improving liquidity. Many of the con-cerns raised by those calling for increased regu-lation predate the emergence of HFT, and thusthose concerns are not particular to HFT. Thereare, however, opportunities for regulators, HFTfirms, and exchanges to continue to work to-gether to monitor and develop internal and ex-ternal “circuit breakers” and consolidated audittrails to ensure continued market stability andintegrity.
 High Frequency Trading 
 Do Regulators Need to Control this Tool of   Informationally Efficient Markets? 
by Holly A. Bell 
No. 731July 22, 2013
 Holly A. Bell is an associate professor of business at the Mat-Su College of the University of Alaska, Anchorage.
 
2
High frequency traders . . .use availablehigh-speed information tohelp determinethe market valueof individual securities.
Introduction 
High Frequency Trading (HFT) is a formof algorithmic trading in which firms usehigh-speed market data and analytics to lookfor short-lived supply and demand tradingopportunities that often are the product of predictable behavioral or mechanical char-acteristics of financial markets. Also called“equity market making,” HFT firms usually hold their positions for less than a minutewhile perpetually looking for buy and sellopportunities.
1
These transactions happenthousands of times a day, take microseconds,and often net less than a penny in profit pershare traded. HFT serves as a tool to facili-tate market efficiency in informationally ef-ficient markets.This is an important time to discuss therole, if any, for U.S. regulators in monitoringor controlling HFT. Countries such as Franceand Germany have recently taken steps to sig-nificantly curtail or even ban HFT activities.Recently in the United States, the Securitiesand Exchange Commission (SEC) proposedadditional regulation under a new rule calledRegulation Systems Compliance and Integri-ty (“Regulation SCI”). This regulation seeks to“formalize and make mandatory many of theprovisions of the SEC’s Automation Review Policy that have developed during the lasttwo decades.”
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Fortunately for HFT traders,according to Andrei Kirilinenko, former chief economist at the Commodities Futures andTrading Commission, the current proposalby the SEC aims “to take existing practicesand make them federal regulations” ratherthan attempting to significantly curtail HFTmarket activity.
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Yet the move does signal a desire by U.S. regulators for an increased andmore formalized regulation of HFT.This paper discusses the role of HFT ingenerating informationally efficient markets.In particular, it examines how the changing velocity of information makes HFT an inte-gral part of contemporary markets. It thenexplores the criticisms of HFT, including thepotential for a two-tiered system, volatility,flash crashes, HFT’s role in market-making,and concerns about market “noise” and integ-rity from an historical and contemporary per-spective to determine if any of those issues areexclusive to HFT. The paper concludes withrecommendations for the roles of regulators,the market, and market participants regard-ing HFT.
HFT in Informationally Efficient Markets
Financial markets are believed to be “infor-mationally efficient.” This term comes fromthe efficient market hypothesis developed by Eugene Fama. The underlying concept of theefficient market hypothesis is that “no simplerule based on already published and availableinformation can generate above-normal ratesof return.”
4
Fama describes the conditionsfacilitating market efficiency as “market[s]where there are a large number of rationalprofit-maximizers actively competing witheach other, trying to predict future market values of individual securities, and where cur-rent information is almost freely available toall participants.”
5
He describes an informa-tionally efficient financial market as “a mar-ket in which prices always ‘fully reflect’ avail-able information.”
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High frequency traderscreate a base of rational, profit-maximizingcompetitors that use available high-speed in-formation to help determine the market valueof individual securities.In informationally efficient markets, HFTis a contemporary tool to utilize available in-formation efficiently to value securities andexecute trades in the market. When the ef-ficient market hypothesis was developed,information was passed on relatively slowly as professional investors gathered aroundtables and examed quarterly and annual re-ports and painstakingly created hand-drawncharts of stock and market activity. HFT is a contemporary application of the same pro-cess that takes advantage of the increasingspeed and quantity of data and the availabil-ity of computer algorithms that can quickly sort through and analyze the data.
 
3
High frequency tradingfacilitates thedissemination of price changeinformation,allowingeven privateinformation tobe reflected in prices well beforeit becomes news.
Efficient markets rely on the efficient dis-tribution of information. This informationresides both inside and outside the market.Within the market, information is containedand reflected in the price of securities. Onceoutside information is known to at least oneperson, it begins to be reflected in the price of a security or the market as a whole. Microeco-nomic information influences the value of a security relative to another security, whereasmacroeconomic information can influencethe market value as a whole. HFT helps dis-seminate this information within marketsquickly and efficiently.The movement and symmetry of internaland external market information are not as-sumed to be perfect. As Fama states, it is “
al-most 
freely available.” One of the early notablecontributions to the field of market efficiency includes a paper published in 1921 by F. W.Taussig, in which he observed that financialmarkets seem to diverge from the ordinary reasoning of supply and demand as they aresubject to manipulation based on informationthat may not be widely known.
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He observedthat technical information—such as whether a position is oversold or undersold—and insiderinformation and rumors all led to fluctuationsnot anticipated by supply and demand alone.In other words, information (and anticipatedinformation) influences market prices morequickly than traditional models of supply anddemand would forecast. This is in part due tothe fact that information cannot be suppliedto everyone at exactly the same time. Asym-metric information in informationally effi-cient markets is not a new concept.Price changes serve as an efficient way todisseminate information, even when everyonemay not immediately know the specific infor-mation. In this way even private informationbegins to be reflected in prices well before itbecomes news. Often by the time informa-tion is made public, price changes have al-ready been made. Paul Samuelson observedthat markets are so informationally efficientthat by the time an individual expects a priceto rise, it has already risen.
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When the FederalReserve announces interest rate changes, forexample, the market has often already adjust-ed prices based on the anticipated news de-rived from other economic indicators. Fallingprices usually indicate negative informationand rising prices indicate positive informa-tion. Dimson and Mussavian provide a morecontemporary version of Fama’s definitionby describing market efficiency as “used todescribe a market in which relevant informa-tion is impounded into the price of financialassets.”
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HFT helps facilitate this process.
The Changing Nature of Information in Efficient Markets
Financial market efficiency has been de-scribed in many ways, including “rational,”“a fair game,” “a random walk,” and “unbeat-able.”
10
However, one common element in allefficient market theories—including those thatclaim markets are inefficient—is the use andimpact of information on markets. The HFTdebate is no exception. The key characteristicthat differentiates HFT from other types of in-formation dissemination is the velocity of thatinformation. When much of the iconic litera-ture that guides our markets was written, in-formation moved relatively slowly, as a review of the history of the efficient market hypoth-esis reminds us. As a result, the analysis of therole of information was very static in natureand focused primarily on intrinsic microeco-nomic factors like dividends, price to equity ra-tios, corporate leadership structures, and riskmitigation through portfolio diversification.Since that time, the velocity of informa-tion—defined as the rate at which informationmoves through the market—has increased ex-ponentially. This has created a need for marketanalysis to be both faster and more dynamic.The development of HFT is both a result of,and a contributor to, this high-velocity infor-mation environment. The Internet, social me-dia, computerized trading platforms for ama-teur investors, the 24-hour availability of news,the global economy, and the fact that 401(k)

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