Dalton Financial Analyst's Opinion on High-Frequency Trading

Chiyoda-ku, Japan, January 11, 2016 (Newswire.com) - ​Alexander Eriksen of Dalton Financial in Tokyo, Japan, has released an article with his opinion regarding high-frequency trading (HFT), and the impact it is likely have on financial markets.

It’s no revelation that technology is, and will continue to, play a significant role in the future of the world’s financial markets, and indeed the banking sector as a whole. Actually, many institutions are considering it the defining factor for their future successes. There is a clear correlation between having the finest technology and profitability, and banks are well aware of this.

High-frequency trading is just the next step in the advancement of financial technology, practiced by specialist firms with the most cutting-edge technology. What we may find in the near future is that the strong emergence of high-frequency trading could make some traders’ positions untenable. In fact, it is likely that the success of a financial house would depend less on traders and bankers, and more on technologists.

High-frequency trading is essentially a form of trading using fibre-optic internet connections and a platform of computers to trade in the financial markets, with transactions being completed in milliseconds. It is literally what it says it is: a platform that allows traders to purchase or sell financial instruments, usually large amounts, in fractions of a second. 

However, there is a problem with this type of trading. It allows traders to profit from millisecond delays in trades. For example, let’s say you place an order for 5 thousand shares in Company X. An algorithm on the trader’s computer will recognise that you have placed that order, then swoop in and buy the shares before you. This is possible due to a faster internet connection, so even though you ordered them first, the trader received them before you. The trader then sells them to you at a slightly inflated price, which most of the time goes unnoticed, as the increase is so miniscule. However, when this is done on a massive scale, the profits become significant.

As a result of this trend, the strongest internet connection speeds are highly sought after. The result of a recent investigation showed that the average speed of a trade in North America is almost 98% the speed of light.

There is, however, a risk of insider trading. Any trader with privileged information regarding a company could indeed act on it milliseconds before the news is made public. They would unlikely be investigated for suspicious trade movements, and yet still profit from the information.

However, any advantages of high-frequency trading (HFT) by balancing markets are massively warped by the issue of front-running. This represents a blow for people with pensions or investments, and the banking institutions that don’t have the technology to be running at 98% the speed of light. Nonetheless, numerous reports have validated that high-frequency trading reduces market volatility, does not pose a systemic risk, and lowers transaction costs for retail investors. For this reason, high-frequency trading is aggressively disputed.

Regulation will inevitably be put in place, and when it does, will more than likely be done on an international G20 scale to avoid market-abusing traders simply relocating to continue their misdemeanours. Yet regulators have inadequate capital to hire skilled people to deal with the problems faced. The majority of capable compliance staff are in such demand that they are being employed by banks, with much higher remuneration packages than regulatory bodies can offer. This situation leaves regulators on the back foot meaning they are always one step behind.

Today, the man who created the platform now works at Investors Exchange (IEX), a trading platform designed to be more transparent, with speed being regulated to avoid market abuse. This is likely to become more popular as HFT gains momentum. A small disruption to the internet connection is created to avoid certain trades arriving before others, which makes front-running impossible, offering a firm belief in equal opportunity for all investors.

A Chicago Federal Reserve letter also made recommendations including a kill-switch to stop trading immediately if something goes wrong, along with profit/loss limits, limits on the maximum position a firm can take in a day, as well as limits on the number of orders that can be sent to an exchange in a certain time period.

In future, we can expect to see regulators come down hard on high-frequency trading to avoid market abuses such as front-running and flash crashes, both of which can leave investors at risk or out of pocket. Most likely, they will adopt some of the recommendations from the Chicago Federal Reserve letter. Some European countries have even gone as far as saying they may ban high-frequency trading altogether, due to the unpredictable volatility it can cause.

Whatever way you decide to look at it, the future is unquestionably, going to be more regulated.

This article was written by Alexander Eriksen of Dalton Financial, and is his own opinion. This does not necessarily reflect the views of Dalton Financial. Dalton Financial is an asset management firm operating out of Tokyo, Japan, since 2011. For more information, please visit www.daltonfinancial.com, email [email protected] or call us on +813 457 90729.