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High-frequency trading (HFT) has inhabited the market for more than a decade, but only during the last couple of years has it become a subject of intense scrutiny, both in Canada and around the globe. Today, HFT—which allows traders to use advanced algorithms and systems to make trades in milliseconds and profit on millions of transactions—is part of the common parlance on Bay and Wall streets.

Different types of HFT strategies exist. Not all of these strategies are bad for the market, but some take advantage of information leakage (the ability to access trading information before others), providing a good return for a few technologically advanced investors at the expense of the millions of people who invest their savings with professional money managers.

HFT emerged in the public realm quite abruptly with the May 2010 FlashCrash, when the U.S. Dow Jones Industrial Average briefly lost almost 1,000 points before rebounding almost 600 points in a very short period of time. It got even more attention when financial author and commentator Michael Lewis asserted in his recent book, Flash Boys, that the “market was rigged” by high-frequency traders.

Read: IIROC team to study HFT impact

The emergence of HFT ultimately changed market dynamics. Previously, the market was mostly made up of retail investors (individuals who buy and sell shares on their own behalf) and institutional investors (large asset managers investing in large size on behalf of pensioners). Both groups typically trade shares based on the fundamental principle of buying or selling according to their view of the underlying value or promise of a company.

However, with the rise of HFT, a larger number of arbitrageurs— traders looking to exploit market inefficiencies—are now added into the mix. In general, these types of traders diverge from retail and institutional investors because they buy and sell shares in a way that is completely disconnected from a company’s underlying value and fundamentals. When describing HFT specifically, Mary Schapiro, former chair of the U.S. Securities and Exchange Commission (SEC), described the practice as having “very little to do with whether you think IBM’s got a great business plan and solid earnings growth in its future and a lot more to do with what’s the minuscule aberrational price move that you can take advantage of.”

One of the most common examples is momentum-type arbitrage trading strategies, in which traders look for signals from large institutional orders inrs in managers bring orders to buy or sell big blocks of shares to trading venues specializing in the execution of much smaller orders (such as the TSX), they camouflage the orders by dividing them into multiple smaller trades. This often creates an imbalance of supply and demand discernible to high-frequency traders with advanced technology. At times, it results in volatility and market impact costs, which hurt long-term institutional investors and the fund investors they represent.

Read: ETFs and HFT: Need for speed

Proponents argue HFT has provided increased liquidity for markets, which, in turn, has tightened spreads and been a boon for retail investors. However, better liquidity and tightened spreads can be overstated, as many high-frequency traders post and cancel their orders in rapid succession.

Ironclad quantitative studies on the impact of HFT—either wholly negative or positive—have been elusive. But if high-frequency traders are making millions by being the fastest, there is a counterparty on the other side of those trades.

In a recent Liquidnet survey of more than 100 traders from around the world, more than half (57%) of respondents said they believe HFT should be a top concern for regulators. And regulatory bodies seem to be listening. For example, the Ontario Securities Commission (OSC) announced earlier this year it may consider measures to regulate HFT as it reviews its market-structure policies, if evidence of predatory activity emerges. The OSC is awaiting the results of a study on the impact of HFT currently being conducted by the Investment Industry Regulatory Organization of Canada. For their part, the SEC and regulatory bodies in the EU have both publicly pledged to take a tougher stance on predatory HFT practices.

Read: Institutional traders concerned by HFT

A host of global proposals have been put forward to combat HFT. Earlier this year, the TMX Group put forward a proposal featuring “speed bumps” to slow down HFT. But these are just Band-Aid solutions. If the industry is to revitalize and bring integrity back to the markets, institutional and retail investors need a place where they can trade freely while being protected from the ever-present risks existing in the current equity market system.

High-frequency traders are not doing anything illegal, but they are using technology to give themselves a leg-up on institutional investors and the millions of people they represent. HFT benefits the very few at the expense of the many, which defeats the purpose of why a market exists—and, as a result, has lessened the overall quality of the markets.

Robert Young is the head of Liquidnet Canada.

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Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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