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HFT or High Frequency Trading is a process where trading in equities, bonds, derivatives, and just about all financial instruments is done through computers driven by algorithms that determine the trading patterns rather than humans trading on the basis of information.
In other words, HFT means that trading in financial instruments is done through computers talking to each other that are powered by complex algorithms that map how trading has to be done.
HFT is a recent phenomenon that arose from the need to make sense of the increasingly complex nature of financial markets.
HFT resembles the 21st century trading paradigm where information is obtained real time and those market participants who can use the information instantaneously benefit more than those who are late to the react to the developments.
Since computers driven by Artificial Intelligence or AI have the ability to react in real time to changing market trends, HFT has revolutionized the way in which financial markets operate in the West and especially on Wall Street. As we shall discuss subsequently, there are advantages and disadvantages of HFT.
The promise of HFT lies in the fact that humans cannot make sense of the rapidly changing market trends and the accelerating changes in financial markets in real time. On the other hand, computers powered by AI have the ability to respond in real time to the changes and the flows of information.
Since asymmetries of information are the real reason why financial markets are imperfect, it is believed that HFT would do away with this anomaly or shortcoming and lead to markets that are more efficient.
Further, it is believed that handling the ever increasingly complexity and the explosion in the volumes of financial products that are traded can only be managed through computers that pack in a lot of punch with their computing power. Indeed, this is the best argument and the justification that is made for the use of HFT as it has the power to revolutionize the way in which financial markets operate.
In the west and on Wall Street, HFT has engineered a revolution in the way Wall Street brokers’ trade with each other and financial firms operate. The use of HFT is being adopted worldwide following the success of its venture in the West.
However, there are many perils of using HFT as well.
For starters, chances of the computer programs going haywire and large-scale swings in the markets is one big danger that HFT poses.
As can be seen from the various flash crashes where the DOW and the NASDAQ crashed abysmally within a few minutes on several occasions within the last couple of years, the potential for dangerous situations to manifest themselves is very high.
Further, as computers make the decisions on trading rather than humans and the AI can sometimes encounter a situation where human intervention is needed, HFT cannot be the solution all the time.
The preferred method would be for a system where the actual human traders have the overall decision-making power rather than the computers alone wherein any potential for the software going haywire is immediately rectified through prompt human intervention.
The other danger that HFT poses is that it elbows out the individual investor and the jobbers or the small traders and bestows all the benefits on large financial firms. Considering the fact that financial markets are supposed to work for the benefit of everybody, HFT moves away from democratization of the market.
Finally, when one considers the promise and the perils of HFT, it is clear that the balance is even and hence, one has to watch how the future of trading in financial markets evolves to a situation that is more in tune with market participants and their desires.
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