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101: High-frequency trading

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Electronic trading on stock exchanges has been around since the 1970s, with the JSE going down this road in 1996.

The days when traders shouted buy and sell orders on a stock exchange floor, known as open outcry, are long gone. Today, computers and algorithms execute most of the world’s equity market trades.

Technological advancements have not only automated trades, but have also brought exceptionally high speed to trading.

Known as high-frequency trading (HFT), this is measured in microseconds — a millionth of a second, or quicker than the blink of an eye.

HFT makes use of sophisticated technology to execute trades at the fastest speed possible; preferably faster than those of competitors.

In the race for speed, proximity matters. In order to reduce latency — the distance that a signal needs to travel — these traders physically place their trading engines next to stock market servers via co-location services.

The JSE opened co-location to clients in mid-2014. Today, about 30% of the value traded in the its cash equities market goes through co-location.

"Not all of that is HFT," says Donna Nemer, head of capital markets at the JSE. "A number of entities use co-location for their institutional clients due to the superior execution capabilities."

High-frequency traders make money by, among other things, being the first to respond to information about stocks.

Profit margins per trade are often small — sometimes a fraction of a cent — but they add up when millions of trades are executed every day.

After the global financial crisis , HFT came under intense scrutiny when its market-manipulating misuses were exposed. For instance, spoofing sees high-frequency traders place orders they never intend to trade on, but which can misleadingly influence the price of a security.

To address this, exchanges have taken to limiting the number of orders that any single computer connection in co-location can place per second.

In the case of the JSE, orders are limited to 300/second for each connection. One firm can have up to three connections.

The JSE uses its own algorithms to detect market abuse, says Nemer.

"What you want in a high-quality, fair, central order book market is transparency of information, where you know the price discovery is honest and that transactions are being executed at or better than the best bid and offer spread," Nemer says, referring to the difference between the best buy and sell price of a share.

But high-frequency traders can gain the upper hand even in this context, intercepting large orders by placing small orders within the best bid and offer spread.

A large order will hit the best price only to find insufficient shares to satisfy the order, causing the price to move before the order can complete.

To circumvent this, the JSE will soon enable institutional investors to match their trades within the visible best bid and offer spread without interference from other market participants.

Unsurprisingly, HFT is controversial.

The Investors Exchange (IEX) — which launched as a stock exchange in August in the US — does not offer co-location, ensuring that all trades are executed at the same speed.

IEX is a direct response to what its founders believe are the unfair and murky trading strategies practised on Wall Street, including paying for an advantage via co-location. It hopes to make equity trading transparent and understandable to ordinary people.

By seeking to bring change, says CEO Brad Katsuyama, "we’ve made a lot of enemies from people who like it just the way it is".

HFT’s proponents say it bolsters liquidity, which in theory should benefit all investors, as the more buyers and sellers there are, the closer to fair value a stock’s price should reach.

"If you get toxic liquidity or predatory behaviour, business will move away from your market, so there is a big incentive for any exchange allowing HFT to get it right," notes Kevin Brady, CEO of A2X, an alternative equity exchange in SA that is in the process of obtaining its licence.

In developed markets, HFT’s share of equity market trading has fallen notably since the global financial crisis, according to research from Orçun Kaya, a Deutsche Bank economist.

In a research note published in May, Kaya argues that HFT has reached its limit as profits are squeezed by relentless competition, costly infrastructure and forthcoming regulation.

Nemer believes the race for speed has reached a plateau.

"I think now the focus will be on other issues, such as the quality of execution and the delivery of data and analytics," she says.