A Slightly Different Take on High Frequency Trading (HFT)
My guess is that HFT will soon become one of those bogeyman words that people automatically associate with "bad stuff" without ever actually understanding what it means. But it is worth understanding the underlying problem, and that problem is not high speed or frequency per se.
As I understand it, when an order to buy, say, 10,000 shares of Exxon gets placed, the purchase will get pieced together by searching across multiple servers where offers are listed and putting together the 10,000 shares in bits and pieces from these various servers. What HFT's are doing (and I am sure this is grossly oversimplified) is that once it sees this order pinging a server, it runs ahead at high speed to other servers and buys up blocks of Exxon at price A and then offers it up to the pokey buying search when it finally arrives at those servers at A+a bit more. That "a bit more" may be less than a penny, but the pennies add up and if done right, there is almost no trading risk.
This is bad, though generally not for us small investors but for our mutual fund companies. For my little trade of 100 shares that might be cleared on the first server, HFT's have no opportunity to play. Moreover, I may not even notice a penny or two difference in the price I get. This is a much bigger deal for mutual fund companies and large investors clearing larger trades, where a few pennies can add up to a lot of money.
An exchange always has to be really careful to maintain its image of fairness, and systematically allowing such behavior, called front-running, is not good for the health of the market. Which is why you are hearing a lot about this.
Here is what you are not hearing, and I will admit that it is all a hypothesis of mine. But it may well be possible that HFT's actually reduce the total cost of front-running to investors. It may be that HFT's real crime is that what they are doing is more transparent and visible than what market makers were doing in the past -- ie they are not increasing the volume of front-running, they are just making it more obvious. I would not be at all surprised if such front-running always existed in market-making (certainly Goldman Sachs has been accused of it) and that HFT's are actually the Wal-Mart or Amazon of front-running -- not doing anything new but doing it cheaper on tighter margins. Kind of ironically, I suppose this is what efficient markets theory would predict for the market in front-running.
If this is the case, while we would rather see front-running eliminated entirely, HFT's may actually be reducing the cost of front-running and making things more rather than less efficient.
