The Impact of High-Frequency Trading on Market Liquidity

1) What is High Frequency Trading?

High-frequency trading (HFT) is a subset of algorithmic trading (AT) that makes up 70% of total stocks bought in the US and 35% of stocks bought in Europe. Although there is no formal definition of HFT, it typically refers to any strategy that quickly sends out waves of orders to the market. In other words, it uses powerful computers to send out a large number of stock orders in a fraction of a second. Although the profit from one stock traded by HFT is minuscule, rarely exceeding a few cents, the sheer volume of trades completed by a HFT algorithm makes HFT an extremely lucrative venture.

A HFT algorithm takes advantage of the “bid ask spread,” which is the difference between the highest price that a buyer is willing to pay for a stock and the lowest price that a seller is willing to accept. The individual looking to sell will receive the bid price, while one looking to buy will pay the ask price. The algorithm takes advantage of this by buying many small amounts of stock, rather than one big one, making the bid ask price lower and increasing profits over competitors.

In the world of HFT, where a fraction of a second could be worth millions, traders have explored every way imaginable to gain an upper-hand over competitors. As a result, traders’ servers are built as close as possible to those of the stock markets, extremely advanced computed are overclocked to reach max operating speeds, and state-of-the-art machines are constantly being replaced to achieve the lowest latency and best performance.

All of this, though, has produced a two massive debates in the world of finance: is HFT unethical because of these advantages over the average investor and does HFT take advantage of the average investor by exploiting bid-ask spreads? Because of these debates, many are petitioning to make HFT illegal. On top of of that HFT has been proven to increase market volatility, see the crash of 2:45 for more info.

2) How does High Frequency Trading Affect Liquidity?

Liquidity: the ability to turn a stock or any other asset into cash.

Liquidity is one of the most important parts of the stock market; without it, the value of a given stock would be meaningless, as it could not be sold for real money. Because of this, liquidity is a main focus among many involved in finance. And with the growing popularity of HFT combined with the importance of liquidity, a debate was sparked: does HFT improve or worsen liquidity? The short answer: it improves market liquidity. But in order to understand why, we must dig a little deeper.

1. Because of the sheer volume of trades that take place because of HFT, there are way more buyers in the stock exchange, which lowers the bid ask spreads. And by lowering the bid ask spreads, sellers get more money for their stocks, improving liquidity.

2. HFT improves competition in the market, forcing prices to be more competitive, which improves liquidity. On top of that, the competition that HFT brings is often in lower-invested areas of the market, which is better for everyone.

3. HFT obviously makes a lot of money, which gets reinvested into the market. HFT algorithms can act as market makers by frequently trading, insuring that there will always be a market for them.

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This content is for informational purposes only. Such information should not be construed as legal, tax, investment, financial, or other advice.