What is High Frequency Trading (HFT)

High Frequency Trading involves powerful computers that execute buy and sell in the blink of an eye. A study revealed that modern computers and advanced algorithms combined can predict market movements and execute trades in under 10 milliseconds.

This level of speed and accuracy comes with its own positives and negatives. HFT is a love or hate technique, as it is the weapon of choice of banks and financial institutions, and is not accessible to smaller traders.

How High Frequency Trading Works?

HFT traders have access to superfast computers and trading algorithms. These algorithms are monitoring the market 24/7 or micromovements. This helps the traders place automatic trades in large numbers, resulting in high liquidity and volume of trades.

The peculiar feature of HFT is the window of the trade. HFTs are normally short-term trades, meaning the liquidity they provide is short as well. This is one aspect of HFT that is often criticized.

Even while operating under such high speeds, HFTs monitor the market carefully and point out the best trade and arbitrage opportunities.

Due to the complexity of this system, HFTs are commonly used by banks and financial institutions with enough funds to spare for the purchase and maintenance of the systems behind successful HFTs.

The popularity of HFTs skyrocketed when exchanges started incentivizing liquidity providers. The SLPs or Supplementary Liquidity Providers of the New York Stock Exchange are a classic example of how HFTs hold a special position at the heart of exchanges.

The crash of Lehman Brothers in 2008 further fueled the need for liquidity, and HFTs largely benefited from this surprise economic downturn.

Advantages of HFT

HFTs are instrumental in providing liquidity to the market courtesy of their huge volume of trades. The speed with which the transactions are executed is yet another advantage of HFTs. 

High-speed transactions with high precision benefit large institutions like banks. A large volume of trades within a short time, along the lines of seconds, is an appreciable feat.

Another benefit of HFT is its ability to eliminate small bid-ask spreads. As market liquidity improves significantly, the overall effect on the spread also becomes positive.

Disadvantages of HFT

As we climb past the silver lining, we start witnessing some harsh realities about HFTs. This is a highly criticized model of trading in terms of fairness. With mathematical models replacing the traditional broker-dealers, human intelligence and diligence are long out of the picture.

This can be problematic at times. For instance, the intraday drop of May 6th, 2010. When investigated, it was found that the drop was a direct result of a massive sell-off initiated by HFTs.

Such high levels of market movements are not ideal for any market, as the ones who suffer the brunt of the fall are often small traders.

HFT in Cryptocurrency Markets

HFTs are slowly finding their way into the cryptocurrency domain as well. With bots, algorithms, and automated trading APIs, they have altered their form but retained their functionality.

This poses a great risk to the market, as the crypto market is dominated by medium to small-sized traders in number. Additionally, crypto assets are known for their high liquidity and price volatility; an HFT added to the equation may very well disturb the equilibrium.

Conclusion

HFTs are a modern and scientific approach to trading, but the lack of human touch and unregulated exposure are features that are undesirable. There is a need for regulatory systems to be put in place to apply a check on HFTs.

If left unattended, HFTs can cause huge market swings, which can be devastating to the average trader.

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