The Impact of High-Frequency Trading on Market Integrity

High-frequency trading employs computers to exploit price discrepancies that appear and vanish within fractions of a second, using fiber-optic cables or wireless transmission to access data quickly.

HFT increases liquidity by making trading easier for investors. Should HFT competition dwindle, this could damage investor trust and lessen market quality.

How Does HFT Work?

HFT seeks to leverage small price differences for maximum profit. This can be accomplished either through market making (buying and selling stocks for a fee), or arbitrage (taking advantage of disparate pricing discrepancies across markets).

Market makers make money off the bid-ask spread, which refers to the difference between how much it costs to purchase an asset compared to selling it, or “selling it at” at different price levels. Market makers can increase profits further through layering orders; placing sell orders above buy orders then cancelling them quickly later to earn profits off spread profits; this practice is known as spoofing and is illegal.

HFT firms use direct market access and co-location services (having servers located near exchange servers) to minimise network latency – the amount of time between sending and receiving trade signals. HFT traders also rely on high-speed data feeds that deliver up-to-the-millisecond pricing and order book information, which they purchase from various sources including exchanges.

How Does HFT Impact Market Liquidity?

HFT has long been considered controversial as it replaces traditional broker-dealers with mathematical models and algorithms to make decisions, bypassing human decision making entirely. Because decisions are made so rapidly – millisecond decisions – HFT could cause sudden market movements for seemingly no discernible reason, as witnessed in May 2010 with its flash crash that saw Dow drop 1000 points within 20 minutes before rebounding again – one government investigation blamed this incident on one massive order that started the sell-off.

HFTs face criticism that their liquidity provision is fleeting. HFTs may use “pinging,” an approach where small orders are quickly placed to exchanges before quickly cancelling them – this makes it harder for other traders to leverage this liquidity source.

However, recent research demonstrates that high-frequency trading improves market quality and stability by decreasing bid/ask spreads and contributing to price efficiency. A study which simulated an interruption of high-frequency trading found no harm caused to markets by its interruption.

How Does HFT Impact Market Volatility?

HFT may not directly cause stock markets to swing, but its influence can increase market volatility and make flash crashes more likely as front-running is common among HFT firms.

Front-running is the practice of purchasing shares on one exchange and immediately selling them on another, in order to capitalize on differences in bid-ask spreads across exchanges. This practice became prevalent after Lehman Brothers collapsed; investors became concerned about liquidity at that point and some exchanges started offering fees and rebates as incentives to ensure sufficient supply.

HFT firms engaging in this activity, however, may quickly reduce market liquidity by pushing out institutional investors that typically provide it – potentially triggering “flash crashes”, where prices drop suddenly and then recover shortly afterwards – something which can severely undermine investor trust and economic growth. Many analysts now have serious reservations that HFT contributes to increased global market instability.

How Does HFT Impact Investor Confidence?

HFT reduces trading costs and allows investors to more closely track prices, but can have negative repercussions for investor trust. Critics contend that HFT gives large financial institutions an unfair advantage while hurting small traders through front running and creating market volatility; furthermore they criticize its use of “phantom liquidity”, which appears one second before disappearing again the next second.

As part of an attempt to ease these concerns, many exchanges offer incentives or rebates to HFT firms in exchange for adding liquidity. Unfortunately, studies show that regular investors do not use the extra liquidity and it may even increase their costs (Haferkorn 2017).

HFT technology creates many opportunities for errors, including software glitches. Such errors can cause massive financial losses to both individual trading firms and the markets they trade on – and can damage the reputations of all high-frequency traders. Therefore, financial regulators must be cognizant of potential risks involved and implement policies which protect investors accordingly.