The practice of high-frequency trading has more in common with operations inside a casino than a trading room floor. Except an HFT mistake could cost billions of dollars more than a misplaced bet at the roulette table.
High-frequency traders win more bets than the lose
A "flash crash" wiped some $1 trillion (685 billion euros) of companies' market value on May 6 when the US Dow Jones industrial average dropped 700 points before rebounding in a matter of minutes. The sudden plunge in prices was partially due to computers setup with high-frequency trading strategies, in which thousands of orders to buy and sell shares are executed in fractions of a second.
And there's a chance such a crash could happen again, according to Nick Nielsen, head of trading at Marshall Wace, a London-based hedge fund.
"There has really been nothing done to fix some of the issues that we had in last May’s flash crash," he said. "To be a bit honest, I am actually surprised that it did not happen during the entire Japanese saga [when a major earthquake and tsunami hit Eastern Japan in March this year]."
The Dow quickly recovered the losses it suffered on May 6
Though there have been no major drops in a market's average, individual companies have seen major fluctuations in share prices occur in fractions of a second. Trading of Progress Energy was halted for a day in September after its share prices plunged from $44.57 to $4.57 in less than a second. Other, less drastic "mini crashes" stopped trading in other stocks including Apple and Cisco Systems, without generating much news.
Regulators eye HFT
HFT raised concerns among regulatory groups on both sides of the Atlantic, and while recommendations have been made there are no new binding rules governing the practice.
In the UK, Dame Clara Furse, former chief executive of the London Stock Exchange, is to head a British government study into HFT. Mary Schapiro, chair of the US Securities and Exchange Commission, has proposed checks on algorithms before they are used. While algorithmic trading and HFT are not synonymous - not all computer-generated trading is done at high speed - HFT firms are using increasingly complex algorithms to trade securities.
The US Commodity Futures Trading Commission convened a technology panel, which recommended that clearinghouses, exchanges, traders and brokers should jointly oversee algorithms, with measures put in place to prevent excessive risk-taking.
More complexity brings new risks
Endangered species: Oil futures traders at the New York Mercantile Exchange
A political drive to impose new regulations and rules at stock exchanges at a breakneck pace in the aftermath of another incident similar to the "flash crash" could actually increase risks in the financial system, Nielsen said.
"With a rush to bring new rules, you bring more layers of complexity, which in turn creates more risks. I would be very scared of a rush to add more layers of complexity to the markets because all they are doing is increasing the risk of something bad happening again," he added.
"I am a bit scared to see what the public response would be if that did happen again. There could be some pretty aggressive regulation coming very quickly, similar to what happened when all of the bank stocks were getting hammered in 2008," Nielsen said.
Fractions of a cent, millions of times
Nielsen opined that the current form of HFT "essentially is a casino."
"They make a lot of bets and they lose a lot of bets. But they happen to win more than they lose," he said.
Peter Nabicht, chief technology officer at Allston Trading, a Chicago-based trading firm, also agreed that the casino analogy had some validity. "Casinos make very small amounts on each bet and HFT firms do the same thing," he said.
HFT accounts for 54 percent of equity trading in the US and 34 percent of equity trading in Europe, according to Tabb Group, a US-based financial technology consultancy firm.
Politicians have 'no idea' about trading
Nabicht and Nielsen agreed that the increasing grip HFT has on the financial markets formed part of an evolution of the financial markets towards increasingly electronic and automated trading strategies.
Promoting 'Stealth:' Deutsche Bank a London trading conference
Michael Levas, founder and chief investment officer at Olympian Capital Management, a proprietary trading firm based in Florida, called for regulators and market participants to embrace the new trading technology shaping the trajectory of the financial markets.
"What is happening in the market place is nothing new," he said. "What is new is technology. We need to understand it and we have to work with it. That is the only way that we are going to be able to fix all the inconsistencies which are prevalent in the market place."
Levas attacked politicians in Europe such as French Finance Minister Christine Lagarde for having "no idea" what it is like to work in the financial markets.
Deutsche Bank launches 'stealth' algorithm
Meanwhile, Deutsche Bank has launched a new algorithm for trading shares that mimics the strategies used by HFT firms to enhance the performance of its mutual and pension fund clients.
Earlier this month, Germany's leading investment bank has rolled out an updated version of its "Stealth" product, which uses complex mathematical models to predict the price changes of shares in microseconds. These decisions will be used to purchase securities for Deutsche Bank's mutual and pension fund clients.
Author: Joe Morgan
Editor: Sean Sinico