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Proposal: The Impact of Algorithmic and High Frequency Trading

on Financial Markets
Introduction
Over the past decade, the use of computer-based trading strategies has rapidly increased. Two
types of strategies exist: algorithmic trading and high-frequency trading (HFT).
Algorithmic trading is the computerized trading of financial instruments; such as, stocks, bonds,
and currencies (Kissell 1). Algorithmic trading requires defining a trading strategy in terms of
mathematical instructions. After these instructions are specified, computers trade by following
these predefined instructions.
HFT is the usage of sophisticated mathematical techniques and high speed computers to trade
financial instruments. HFT differs from algorithmic trading in several ways. First, algorithmic
trading is implemented with a previously defined trading strategy (Kissell 39). In contrast, HFT
makes both investment and trading decisions simultaneously. Second, HFT typically involves
entering and exiting trades within minutes, seconds, milliseconds, and/or even microseconds to
capture small, guaranteed profit known as arbitrage. Unlike HFT, algorithmic trading is not
risk-free. This is due to longer timeframes between opening and closing trades and the overall
trading strategy is susceptible to traditional market risks. Thus, a key focus in developing an
algorithmic trading strategy is modeling and analyzing risk, then implementing a risk
management and/or reduction, rather than acquiring risk-free profit.
Algorithmic trading and HFT are not without their consequences. Numerous negative events,
volatility, and uncertainty in financial markets have been thought to be a result of algorithmic
trading and HFT. The specific aims of this report are:
1. Determine the effects of algorithmic trading and HFT on market volatility
2. Determine if certain negative financial market movements are a result of algorithmic
trading and/or HFT
3. Determine if algorithmic trading and/or HFT creates an unfair market for retail
investors.
Analysis
I.

More volume means more influence

Algorithmic trading and HFT was quickly adopted in the early 2000s numerous by banks,
institutions, pension funds, and hedge funds (HF). Algorithmic trading and HFT now account for
the majority of present-day market volume (Figure 1).

Figure 1 Computerized trading strategy market volume (Kissell 12, 14).


Note that the HFT total market volume is contributed by several constituents. Market makers
(MM) are those that provide liquidity in financial markets - allowing people to buy and sell a
financial instrument and by setting buy and sell quotes. Traditionally, a market maker was a
human trader which determined these buy and sell quotes to match buyers and sellers. This
process is now done algorithmically, and known as automatic market making (AMM). An
AMM system uses advanced computer systems to enter quotes and facilitate trades (Kissell 40).
Automatic market makers take advantage of arbitrage by accepting a buy or sell order and
matching it with an existing order with a higher sell price or lower buy price.
It is no surprise that the ability to generate risk-free profit has attracted lots of individuals and
institutions to participate in market making. Because AMMs utilize split-second decision
making and low latency communications to route and execute orders, they have the ability to
share incoming orders to multiple exchanges to attempt to facilitate successful market making
amongst several MMs without significantly affecting order execution time. So rather than
compete with one another, market makers decided their best chance of survival if they work
together. This ensures a market maker is nearly always able to fulfill both buy and sell orders for
profit. This is accomplished by sending buy and sell order through intermediate exchanges,
known as dark pools, before they arrive at the New York Stock Exchange (NYSE) and
NASDAQ for the rest of the market to see. This entire process is known as fragmentation.
Some argue fragmentation allows market makers to manipulate buy and sell orders before they
arrive at the NYSE and/or NASDAQ, a process known as front running. Essentially, the belief
is that there is either some information leakage occurring in the dark pool or the interaction with
high frequency orders is toxic, meaning that the high frequency traders are able to learn
information about the order, such as the urgency of the investor or the number of shares that still
need to be executed. In turn, they adjust their prices based on leaked knowledge. (Kissell 22).
II. The benefits of MM provided liquidity
There is evidence that market makers actually provide stability and increased liquidity in
markets. Because there is always a MM ready to buy and sell stock, traders are able to swiftly
enter and exit trades with an almost guaranteed assurance of instant order execution. This
scenario creates market efficiency and stability any attempt to manipulate or front-run orders
for a higher or lower price would be instant met/thwarted with selling or buying, respectively.
I dont think that anyone would prefer the old system of New York Stock Exchange specialists
and NASDAQ market makers and their particular privileges., says Kevin Callahan (Schwartz
2). Every trader needs to realize that high-frequency trading firms are indeed the new market
makers. As such, they are the counterparty to many trades. They can provide liquidity and that
immediacy if you demand it. But when they are the counterparty, on many occasions they are
trading for a distinct financial purpose. They are trading to make money! You need to be
informed and smart about how you deal with that., remarks Callahan (Schwartz 2).
III. The impact of algorithmic trading and HFT
Similar to other industries, financial markets evolve with new technology and discoveries.
Market participants have been forced to adapt and overcome the rapidly changing landscape of
trading or face obsolescence. The rise of algorithmic trading and HFT-based funds have stripped
profits from traditional asset management funds. For example, during the period of increased

high frequency trading activity (2006 - 2009) these funds were reported to be highly profitable.
Conversely, over the same period the more traditional funds were not as profitable as they had
been previously, especially in comparison to the high frequency traders. says Kissell (Kissell
13).
IV. Significant movements in financial markets since the inception of algorithmic trading and
HFT
Perhaps the most significant economic event in the past decade was the financial crisis which
occurred in 2008 - 2009. In the aftermath, many traders and economists speculated that
algorithmic trading and HFT played a role or exacerbated the market reaction. However, even
during the peak of the financial crisis, high frequency trading was only about 33% of total
market volume (Kissell 14).
More recently, the Flash Crash which occurred on May 6, 2010 was believed to be a result of a
massive imbalance of orders (Schwartz 8). Stephen Sax of FBN Securities believes that HFT
caused this massive imbalance of orders. We have high-frequency trading because we have
market fragmentation., says Sax (Schwartz 8). If we didnt have fragmentation, we wouldnt
have excessive high-frequency trading. So the answer is yes (referring to the question: Did high
frequency traders cause the Flash Crash?) (Schwartz 8).
Sax goes on to say - My understanding of high-frequency trading is very simple. Things trade in
about 40 or 50 different venues. Certain people have access to these venues, to direct access, to
direct pipes that not everybody else has. They are basically able to buy and to sell before
somebody else buys and sells. (Schwartz 9). This principal can create increase volatility and
cause rapid changes in quotes for financial instruments.

Figure 2 Stock chart of SPDR S&P 500 ETF (Ticker: SPY) showing significant price changes
from 2008-2009 financial crisis and May 6, 2010 Flash Crash.
Conclusion

Algorithmic and high-frequency trading presents both pros and cons, which are often a matter of
opinion and thus subjective. Nonetheless, their impacts are evident and non-negotiable. HFT is
simply a testament to how financial markets change and evolve. In previous decades, trades were
called in to the floor of the NYSE via a phone. Advancements in computing and technology
during the 1980s and 1990s allowed for traders to use computer software to place orders.
During that time, many individuals believed severe consequences would occur as result of this
new method of placing orders. Algorithmic trading and HFT is simply an extension of this
technology. Technology changes and so must the people employing or utilizing it. Overall,
algorithmic trading and HFT is still in its infancy and remains unperfected. As time passes,
further laws, regulations, and advancements will likely refine HFT and ultimately become an
essential and transparent component of financial markets.
Glossary
arbitrage a condition under which an investor is guaranteed to make a profit regardless of
circumstances (Roman 5).
automatic market making (AMM) the use of advanced computer systems to enter quotes and
facilitate trades.
dark pools a collective group of secondary exchanges which serve as a matching system for
buy and sell orders (Kissell 21).
fragmentation the concept that buy and sell orders flow through multiple secondary
exchanges and/or dark pools before reaching a primary exchange such as the NYSE or
NASDAQ to ensure liquidity.
front running the belief that trade information accessible by dark pool market makers is used
to manipulate quotes for buy and sell orders.
liquidity a gauge of how quickly an investor/trader can buy and sell financial instruments.
market maker a dealer of financial instruments who is always willing to accept buy and sell
orders for determined quote prices.
New York Stock Exchange (NYSE) the worlds largest stock exchange located at Wall Street,
New York
References
1. Kissell, Robert. The Science of Algorithmic Trading and Portfolio Management. 2014. Internet
resource.
2. Schwartz, Robert A, John A. Byrne, and Gretchen Schnee. The Quality of Our Financial
Markets: Taking Stock of Where We Stand. New York, NY: Springer, 2013. Internet resource.
3. Roman, Steven. Introduction to the Mathematics of Finance: Arbitrage and Option Pricing. New
York, NY: Springer, 2012. Internet resource.
4. Gliner, Greg. Global Macro Trading: Profiting in a New World Economy. 2014. Internet
resource.
5. Chan, Ernest P. Algorithmic Trading: Winning Strategies and Their Rationale. 2013. Internet
resource.