Over the years, storied Investment banks such as GS, JPM, CS et al, next-gen HFT/Electronic trading firms like Tradeworx Inc, Tradebot Systems, KCG etc. and even some large hedge funds have developed several nouveau high-frequency strategies that tend to exploit the inherent inefficiencies in markets - and along their way, made and continue to make some big bucks for participants and investors. Before diving into the "why" aspect of things, I think, it’s important to first understand the "what" and the "how" aspects of this new, evolving and ever-controversial topic.
What is HFT?
Investopedia defines HFT as "A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds." Clearly, this is a technology play - a very fast one - that ensures survival of the fastest and by this I mean we’re talking about executing orders in less than 5 milliseconds (did I just say 'flash trade'?). To achieve this, HFT firms use complex computer-generated algorithms to analyze multiple markets and execute buy-sell orders based on market conditions with the singular objective of making boat loads of money for their investors. Now, the next (logical) question that comes up is -
What purpose do Capital markets serve?
In my view, it's a fair marketplace to exchange (buy/sell) any equity, debt or derivative instruments with the prime objective of bridging suppliers of capital (institutional and retail investors) with consumers of capital (businesses, governments and individuals). So how does HFT contribute to that purpose?
The effects and implications of HFT strategies are the subject of ongoing research and there is a view that it contributes to creating liquidity, narrowing bid-ask spreads and making investing cheaper for all participants in the marketplace (i.e. you and me) - which is one of the fundamental premises of efficient markets. That said, on the flip side, it also contributes to increased volatility and less stringent risk controls that could lead to a potential flash-crashes, similar to the one in May 2010.
US Exchanges (NASDAQ, Direct Edge and BATS) have been allowing and encouraging investment banks, hedge funds and HFT firms to co-locate their technology systems in-house i.e. on the exchange floors - to let them gain a speed and execution advantage in trades. As a consequence, we're seeing these exchanges gain market share from the less automated ones like NYSE et al. And, then there is IEX - an exchange owned exclusively by a consortium of "buy-side" investors with the sole mission of institutionalizing fairness in the markets. Only time can tell how effective IEX will be.
To put things in perspective, we must understand and accept the fact that global capital markets have evolved over the years - at least in the developed and developing worlds and what we see now is an outcome of that process. We're yet to hit a high note in high-frequency trading. Until then, it's rational for us to observe, learn and comprehend best practices emerging from this space and see how things unfold into the new normal.