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High Frequency and Algorithmic Trading | Indian School of Business (ISB)

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May 16, 2013 | Thursday

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POST EV ENT SUM M ARY Prof. Ramabhadran S. Thirumalai, an assistant professor in the

Finance area at the Indian School of Business, Hyderabad, took the CFA charter
holders and students and ISB students on a trip down the world of High Frequency and
Algorithmic Trading. The session can be summarized as follows:
Algorithmic Trading: According to Hendershott, Jones and Menkveld (2011),
algorithmic trading is the use of computer algorithms to automatically make certain
trading decisions, submit orders, and manage those orders after submission.
Algorithmic traders supply liquidity to the market, attempt to decrease the price impact
of trades by splitting orders across trading locations and over time help in achieving
better fill rates, faster executions and reduce manual errors like the fat finger effect.
The counter argument is that they consume liquidity which leads to wider spreads.
Hendershott, Jones and Menkveld (2011) in their paper find that algorithmic trading
improve market quality and hence benefits the market.
High Frequency Trading on the other hand is the use of extraordinarily high-speed
and sophisticated computer programs for generating, routing, and executing orders.
According to Rosenblatt Securities, high frequency traders accounted for about 50%
of the U.S. trading volume in 2012, down from 66% in 2009.
Proprietary trading desks are mainly engaged in high frequency trading. Some
exchanges allow high frequency traders to colocate their servers next to the
exchanges servers so that orders can be quickly executed with minimum latency.
There is no human interaction for trade execution. Firms use quant-based algorithms
and positions are opened and closed within seconds. They usually do not carry any
overnight positions. High frequency traders are often accused of making money at the
expense of slow traders using strategies like stuffing, smoking and spoofing.
The best way to distinguish Algorithmic Trading (AT) and High Frequency Trading
(HFT) is to think that all HFT is AT but not all AT are HFTs. That is, some AT do have
long-term positions.
Instances of HFT/AT Problems: BATS share fell to about less than a penny just in a
few minutes after it started trading on BATS exchange. Another example is the
Knightmare on Wall Street where Knight Capital Group Inc. had an algorithm that
lost $10 million a minute and ran for close to 45 minutes.
Importance of HFT: According to Brogaard, Hendershott and Riordan (2013) there are
many important characteristics of HFT
a. Prices changes due to HFT are relatively more permanent
b. HFT activities are correlated with public information
c. HFT participants love money when they supply liquidity
d. HFT helps better price discovery
Regulations: There are calls for regulating the High Frequency Trades from sections of

http://www.isb.edu/events/industry-events/high-frequency-and-algorithmic-trading

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8/31/2014

High Frequency and Algorithmic Trading | Indian School of Business (ISB)

investors who believe that HFT leads to servers and market crashes. There are doubts
about their risk and management practices and it is known to generate profits at the
expense of small traders.
Except Germany which requires licensing to engage in HFT, other countries have not
introduced any high frequency trader-specific regulations, though they are considering
various actions/regulations such as to ban it, restrict number of messages per second,
charge each message and keep minimum latency for trade execution etc.
Given the far lower profitability of high frequency traders in recent years, it is not clear
how long HFT will continue to account for a large proportion of trading volume.
References:
1. Hendershott, T., Jones, C.M., Menkveld, A.J. (2011) Does Algorithmic Trading
Improve Liquidity?, The Journal of Finance, VOL. LXVI, NO. 1.
2. Brogaard, J., Hendershott, T., Riordan, R. (2013) "High Frequency Trading and Price
Discovery", (April 22, 2013). SSRN: http://dx.doi.org/10.2139/ssrn.1928510

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