High-frequency traders (HFTs) are engaged in an arms race. To beat their competitors, each is spending increasingly large sums on expensive technologies to speed their trading. If actions are not taken to stop this arms race, investors will be worse off and economic welfare will decline.
Numerous studies – including the recently released UK Foresight HFT project – have shown that transaction costs for both retail and institutional traders decreased substantially with the growth of high-frequency trading. The cost savings are easy to understand. Compared with human dealers, computers have considerable advantages. They have perfect attention spans, follow instructions to the letter, do not allow their emotions to cloud their judgment and they watch and learn from thousands of sources of information simultaneously. Nor do they cheat and they work for far less and require smaller offices. These advantages have greatly reduced transaction costs as many HFTs compete with each other to serve us now.
What HFTs know is that being very fast is not enough to be profitable. They must be faster than their competitors. The fastest HFTs get the best places in line when quoting to trade, they avoid trading when they no longer want to trade and they take valuable trading opportunities when they first appear.
Slower HFTs lose out because faster competitors beat them to trades or trade with them to their disadvantage when market conditions have changed.
Facilitating this is a technology arms race. HFTs use extremely fast computers reading hyper-efficient specialised code, locate their servers next to exchange servers to minimise communication times and pay for special high-speed data feeds and for the shortest communication lines between exchanges. And increasingly, they even hard code their software on to silicon chips to minimise response times.
Unfortunately, no study has yet considered the long-term implications of the arms race: the fastest HFTs will eventually drive out their slower competitors and only a few high-frequency trading firms – perhaps just one or two – will survive. The high costs of acquiring the technologies needed to be fast enough to compete successfully will become an insurmountable barrier to new competitors. Indeed, these costs already prohibit all but the most wealthy and wildly optimistic potential competitors.
Decreasing competition among HFTs will be a very troubling outcome of this winner-take-all arms race. When the competition among HFTs thins out, the HFTs will no longer have to quote aggressive prices to obtain order flow. Investors will have to pay high prices when they buy and they receive lower prices when they sell. The costs of trading will rise.
Economic welfare will suffer because high trading costs will make investing in equities less attractive to investors. Corporations that need to raise capital to fund new projects will have to sell stock at lower prices to attract investors, which will increase their capital costs. Fewer projects will be funded and fewer jobs will be created.
Fortunately, a small and easy to implement change in exchange trading rules can substantially reduce the incentives to acquire the expensive trading technologies now required to compete successfully as an HFT. Regulatory authorities could require that all exchanges delay the processing of every posting, cancelling and taking instruction they receive by a random period of between 0 and 10 milliseconds.
Without this rule, any HFT who has a one millisecond advantage over a competitor will beat that competitor 100 per cent of the time. With this rule, the faster competitor will beat the slower one only 60 per cent of the time. If the two competitors were equally fast, one would beat the other only 50 per cent of the time. Both traders would still want to be faster but the benefits of speed would be greatly reduced.
This small change would greatly reduce expenditures on speedy technologies by HFTs without any negative effect on the quality of the markets. Instead, by lowering the costs of entry, it will ensure that high-frequency trading remains a highly competitive business in which traders primarily compete against each other by improving prices and quoted sizes. The current competition in which HFTs invest in technologies whose only benefit is to give them an advantage against their competitors provides no benefit to public investors.
The markets need to be slowed, but not because high-frequency trading is dangerous or unfair. The markets need to be slowed to stop an arms race that eventually will kill competition and increase investor transaction costs. Delaying the processing of all orders by a trivially small random time period of between 0 and 10 milliseconds would be sufficient to ensure that HFTs will forever provide the extraordinarily low transaction cost markets that they have created.
Larry Harris holds the Fred V. Keenan Chair in Finance at the USC Marshall School of Business. He was chief economist of the SEC between 2002 and 2004.