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High-Frequency Trading: Unsafe at Any Speed?

You may have heard news reports recently about the controversy on Wall Street over high-frequency trading.

Though the practice isn't new, it has received fresh attention in recent months as multiple regulatory agencies have launched investigations of high-frequency trading (HFT) and HFT firms. The U.S. Department of Justice, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the FBI, and the New York Attorney General's office all have confirmed that they are looking into high-frequency trading and how it's being used or possibly misused.

Just what is high-frequency trading?

The term "high-frequency trading" is not clearly defined. It has been applied to a variety of practices, some of which have divided Wall Street over whether they help, hurt, or have no impact on investors; sometimes it's even used as a catch-all phrase to describe the use of automated electronic trading. High-frequency trading generally involves lightning-quick computer-driven trades done in milliseconds and even fractions of a millisecond. Trades are based on proprietary algorithms designed to analyze massive data feeds in order to identify and exploit small price advantages, generally by trading in high volumes. For example, an HFT strategy might involve submitting simultaneous orders for the same security to different trading venues to try to profit from small price differences. HFT computers often are located as closely as possible to an exchange or data feed provider to minimize the amount of time it takes for data or orders to be transmitted or executed.

The SEC estimated in 2010 that at least 50% of all equities trades at that point were high-frequency trades.* High-frequency traders may include hedge funds, firms that trade on their own behalf, or the trading desks of multiservice broker-dealers.

Why is there so much discussion about HFT?

Much of the recent attention to HFT has to do with whether use of superfast data feeds has given high-frequency traders an unfair advantage over other investors. One issue under investigation involves a practice known as "payment for order flow," in which traders are compensated by a trading venue for routing customers' orders there to be executed. Critics argue that payment for order flow could give broker-dealers a financial incentive to send orders to a particular venue to be filled rather than ensuring that a trade is executed at the best possible price for the customer.

Like high-frequency trading, payment for order flow is not new. However, the lightning speed at which data moves now has raised questions about whether the practice can be abused. Concerns have been raised about whether institutions that pay for high-speed access to orders or data about order flow are able to use that information to front-run those orders (trade in advance of the execution of the orders). Critics charge that an HFT computer that knows a large order has been placed on an exchange could essentially cut in line before it's filled, immediately buy shares of that security on a venue with outdated lower prices, and then sell those shares milliseconds later at the slightly higher price of the original order.

For example, index mutual funds must periodically buy and sell securities to reflect changes in the composition of a particular index. Turnover in the securities that comprise, say, the S&P 500 can trigger waves of large buy and sell orders from every S&P index fund. An HFT computer programmed to "see" those large orders before they're executed could potentially trade quickly enough to take advantage of advance knowledge about details of those fund orders, which could in turn affect the price at which the original orders are executed. Critics say an institution with privileged access to information about order flow could potentially even trade on its own behalf based on information about incoming orders from its own clients before actually executing those orders.

Also under investigation is whether some high-frequency traders use information about order flow to try to manipulate prices by flooding the markets with large amounts of false orders that are intended to move a security's price so the HFT can profit from price differences that may be as little as a penny.

High-frequency trading and the proliferation of so-called "dark pools" as trading venues in recent years are not necessarily bad; the debate is over whether they have facilitated abuses such as insider trading.

How HFT can affect investors

For most individual investors, the impact of high-frequency trading is probably minimal. The bigger question would likely be how any such disadvantages in the execution of trades might affect the trading costs of large mutual funds, which are paid indirectly by a fund's investors out of the fund's assets. Another concern is the extent to which high-frequency trading could exacerbate market volatility. The SEC's report on the May 2010 "flash crash" found that HFTs were responsible for a large percentage of the total volume of trades at exchanges during the price decline, and that high-frequency trading contributed to the extreme volatility.

Is there an upside to all this?

A sizable contingent on Wall Street contends that not all high-frequency trading involves the questionable practices under investigation. Done right, they say, HFT has increased competition and improved market liquidity, and that greater efficiency in matching buyer and seller has resulted in lower trading costs. They argue that HFTs function in much the same way as a website you might use to research the cost and availability of a room at multiple hotels. According to this analogy, the fee a hotel pays for the listing may ultimately be passed on to the consumer in some way, but it also enables consumers to comparison shop, and the increased competition can help drive down prices. Supporters say that high-frequency trading firms that serve as market makers can work in much the same way. And dark pools, they say, enable shareholders with a massive stake in a particular security to trade large numbers of shares without a large trade having as much impact on the price of the security as it would if traded on one of the public exchanges.

Your rights as an investor

Many broker-dealers generally say that their existing systems are designed to obtain the best possible price across multiple market makers for any given trade. Your account agreement will outline whether you may request that your trades be executed on a particular exchange. However, even if a broker permits customers to specify where trades are executed, they may limit that service to high-volume traders or charge for it, which could eliminate any potential savings on the purchase price.

According to the SEC, brokerage firms are required to disclose annually whether they accept payment for order flow, and they must respond to a client's written request for information about where their trades were executed over the previous six months, as well as the source and nature of any payment for order flow that was received on those orders.

The bottom line

If you're like many Americans, working toward long-term financial security depends on much more than the amount you're paying in trading costs. For individual investors who are focused on the long term rather than on day trading, the direct impact of HFT on their trading costs for individual stocks may be relatively small. It certainly pales compared to major challenges such as saving to build a nest egg or selecting an asset allocation strategy. Don't let headlines distract you from continuing to pursue your financial goals.

*Source: Securities Exchange Act Release No. 34-61358, 75FR 3594, 3606 (January 21, 2010).

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Kenneth S. Rakes has 25 years of experience in public accounting and is a graduate of John Carroll University. Ken provides tax planning and preparation services for individuals, partnerships, corporations, estates, and trusts. Ken is a Personal Financial Specialist (PFS) providing retirement, estate, investment, insurance, and education planning for individual clients with an emphasis on the tax implications of planning decisions. Ken's other areas of expertise include: Manufacturing, Wholesale, Retail and Service Industries, Non-Profit Organizations and Sub-Chapter "S" Corporations.