HFT in the FX Markets.
Here is a Topic I spotted trending this week on the web; High Frequency Trading (HFT) in the Fx Markets, written by Jubin Pejman (Article Source: http://EzineArticles.com/6755854). HFT has taken quite some bashing in 2011, and certainly, its deployment as a strategy has been fiercely debated. High Frequency Trading (HFT) consists of the predictive buying and selling of contracts using algorithmic trading software and ultra low latency trading infrastructure where fractional increments of money can be earned in sometimes microseconds (millionth of a second). The trading technique as such as been used in various forms as markets evolved and equity trading matured.
A recent report by BIS reflects the role of HFT in FX marketplaces. The report says that, there is an increasing use of HFT in FX market in the past few years as there is greater infrastructure available for electronic trading. It was found that, in the FX market, HFT was active in most liquid currency markets and prevalent among dominant currencies. It relied on operating high volume but very small orders, maintained low-margins along with low latency.
This meant that all orders were placed and withdrawn in a matter of a few milliseconds. Specific ‘algorithms,’ which analyzed the market, were used to perform these strategies. Another noticeable trend was that most traders adopted short risk holding periods of less than five seconds for greater efficiency.
The report predicts that HFT will spread to currencies, which are traded in lesser volumes as well and will likely be used in currency markets of emerging economies.
HFT is found to have a profound impact in the FX market places where it has been deployed. HFT effectively increases and distributes liquidity amongst all market segments. Though it does bring in greater efficiency into the system, it also cuts down on the profit margins. The true understanding of HFT’s impact on the FX market ecosystem will require a longer period.
So what really has been the effect of HFT on the market generally?.
The most obvious impact is that spreads are tighter in normal times, particularly at the top of the book. There are questions about the quality of liquidity, however, with claims that liquidity has been impaired for larger orders. Moreover, as we note in the report, the quality of a bid or ask is determined by more than just its price. The size of the quote and its longevity matters too.
The effect of spread compression and depth of book, however, is mostly an issue of redistribution of profit around the marketplace.
A number of complaints levelled at HFT firms often reflect the fact that they are taking margin from the party complaining. One example of this is the accusation of predatory pricing. This is sometimes mislabelled front-running. But front-running implies advance ‘insider’ knowledge of a trade. HFT firms don’t have advanced knowledge of the trade as a whole. Rather they detect patterns in trading which are indicative of a large trade coming to market and take advantage of that piece of information (which is available to the whole marketplace). In doing so, they are taking profit at the expense of another participant, but this should be best viewed primarily as redistribution.
Turning to the issue of the comparison between HFT in equities and HFT in foreign exchange, there are some significant differences between the two. An important difference is the nature of the underlying demand in foreign exchange versus equity. There is wider diversity of participants in foreign exchange and arguably more underlying demand. But there are also signs of convergence, with the foreign exchange market becoming more order driven, rather than quote driven.
In summary, HFT in FX is a rapidly evolving phenomenon. It is having a notable effect on the structure and functioning of the FX market. It is causing behavioural changes in other market participants that may have an impact on the resilience of the system as a whole. Watch this space.