High-frequency trading (HFT) is a type of algorithmic trading in finance characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools. While there is no single definition of HFT, among its key attributes are highly sophisticated algorithms, co-location, and very short-term investment horizons in trading securities. HFT uses proprietary trading strategies carried out by computers to move in and out of positions in seconds or fractions of a second.
In 2016, HFT on average initiated 10–40% of trading volume in equities, and 10–15% of volume in foreign exchange and commodities. High-frequency traders move in and out of short-term positions at high volumes and high speeds aiming to capture sometimes a fraction of a cent in profit on every trade. HFT firms do not consume significant amounts of capital, accumulate positions or hold their portfolios overnight. As a result, HFT has a potential Sharpe ratio (a measure of reward to risk) tens of times higher than traditional buy-and-hold strategies. High-frequency traders typically compete against other HFTs, rather than long-term investors. HFT firms make up the low margins with incredibly high volumes of trades, frequently numbering in the millions.
A substantial body of research argues that HFT and electronic trading pose new types of challenges to the financial system. Algorithmic and high-frequency traders were both found to have contributed to volatility in the Flash Crash of May 6, 2010, when high-frequency liquidity providers rapidly withdrew from the market. Several European countries have proposed curtailing or banning HFT due to concerns about volatility. Other complaints against HFT include the argument that some HFT firms scrape profits from investors when index funds rebalance their portfolios.
History
The rapid-fire computer-based HFT developed gradually since 1983 after NASDAQ introduced a purely electronic form of trading. At the turn of the 21st century, HFT trades had an execution time of several seconds, whereas by 2010 this had decreased to milli- and even microseconds. Until recently, high-frequency trading was a little-known topic outside the financial sector, with an article published by the New York Times in July 2009 being one of the first to bring the subject to the public's attention.
On September 2, 2013, Italy became the world's first country to introduce a tax specifically targeted at HFT, charging a levy of 0.02% on equity transactions lasting less than 0.5 seconds.
Market growth
In the early 2000s, high-frequency trading still accounted for fewer than 10% of equity orders, but this proportion was soon to begin rapid growth. According to data from the NYSE, trading volume grew by about 164% between 2005 and 2009 for which high-frequency trading might be accounted. As of the first quarter in 2009, total assets under management for hedge funds with high-frequency trading strategies were $141 billion, down about 21% from their peak before the worst of the crises, although most of the largest HFTs are actually LLCs owned by a small number of investors. The high-frequency strategy was first made popular by Renaissance Technologies who use both HFT and quantitative aspects in their trading. Many high-frequency firms are market makers and provide liquidity to the market which lowers volatility and helps narrow bid–offer spreads, making trading and investing cheaper for other market participants.
Market share
In the United States in 2009, high-frequency trading firms represented 2% of the approximately 20,000 firms operating today, but accounted for 73% of all equity orders volume. The major U.S. high-frequency trading firms include Virtu Financial, Tower Research Capital, IMC, Tradebot, Akuna Capital and Citadel LLC. The Bank of England estimates similar percentages for the 2010 UK market share, also suggesting that in Europe HFT accounts for about 40% of equity orders volume and for Asia about 5–10%, with potential for rapid growth. By value, HFT was estimated in 2010 by consultancy Tabb Group to make up 56% of equity trades in the US and 38% in Europe.
As HFT strategies become more widely used, it can be more difficult to deploy them profitably. According to an estimate from Frederi Viens of Purdue University, profits from HFT in the U.S. has been declining from an estimated peak of $5bn in 2009, to about $1.25bn in 2012.