Challenges for High Frequency Trading in 2010

I read an interesting article in the FT earlier this week entitled High Frequency Trading (www.bit.ly/4J9ERj).

The main points were that High Frequency trading now accounts for 42% of US equity volume. This has been driven by co-location strategies, placing servers within an exchange data centre in addition to unfiltered or naked sponsored access to gain faster access to exchange system.

Specifically, this involves piggy backing on a brokers id to place orders directly into the market without the broker conducting pre trade checks, reducing latency by 400 milliseconds.

The key challenge for brokers is :-

(i) how to supervise 1000s of trades per second, many of which are conducted faster than the blink of an eye
(ii) balance the need for systematic Risk Management as well as ensuring that there are no potential breaches of credit and capital limits

Natural Evolution
It is my view that the whole debate around High Frequency trading needs to be embraced. What we are seeing is the natural evolution of the markets to lower execution costs and seek out the best price possible. We should remind ourselves that this is a natural evolution of the equity markets. It is only 10 years ago that total transaction costs were 1.1% compared to the 0.33 to 0.64% that is delivered today. These changes have only been achieved through technology innovation and market evolution.

Arbitrage Opportunity
HFT provides much of the liquidity in today’s market, trading arbitrage opportunities and bringing markets such as futures and cash along with Exchange Traded Funds (ETF) and net assets, into tighter alignment. In addition, HFT increases market efficiency, closer pricing gaps and overall tighter bid /offer spreads.

As shown by a recent report by the Aite group, the latency benefits of HFT against convention Direct Market Access is significant

o Naked / Unfiltered access               250 to 300 microseconds
o Sponsored Filtered access               550 to 750 microsecond
o Direct Market Access (DMA)          4,000 to 8,000 microseconds

Key Challenges
In today’s environment, the SEC is seeking a level playing field for both retail and institutional market participants. Key to this is seeking a balance in how privileged sponsored market access is managed in both providing liquidly and driving down best execution price.

In addition, the sponsoring broking community need to look long and hard at how to monitor trades in real time and prevent erroneous trading. In an environment where thousands of trades are conducted per second, brokers need to ensure that the potential systematic breaches of both credit and capital limits are avoided at all costs. The consequence of not achieving this is that the SEC will move towards prohibiting HFT which a highly functional and effective equity market does not need.

IAN ALDERTON
Email : ian@IanAlderton.com
Tel : +44 (0) 7702 777770

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