Does the High Frequency Trading debate matter for China?

Written by Victor Fan || April 14 2014

High frequency trading (HFT) has roughly been in existence since 1999 in the US as execution times have shortened from several seconds to millisecond or even microseconds due to advanced trading technologies and a general demand for increased speed. Figures from August 2013 showed that in the global FX market, HFT took approximately 40% of the total trading volume, within which, almost half of the volume happened in the spot market. For the global futures market, HFT volume represents about 40% of the total volume. In the equities market in the US, HFT volume took approximately 73% of all equity order volume. Typical strategies executed by HFT traders are trading ahead of index fund rebalancing, market making, ticker tape trading, event arbitrage, statistical arbitrage, news-based trading and low-latency strategies.

Rigged?

Michael Lewis' new book, “Flash Boys”, argues that the US stock market is "rigged" because of HFT; the book has ‘mainstreamed’ the ongoing debate on HFT in the US. Recently, there was a debate on CNBC, between Katsuyama, one of the key player’s in Lewis’s book, and O'Brien, CEO of the BATS exchange, arguing whether HFT is good or evil and whether algo-robot should replace human traders. The debate halted some trading on the NYSE as traders listened in, but the debate also raised the interest of the US public. Other media sources such as The Economist also raised a poll on their website to test public’s attitudes towards HFT.  

An Open-ended Debate

Although HFT has been developing in the US for approximately 15 years, the pros and cons of HFT are still controversial. One advantage of HFT is the liquidity that the trading brings to the market. That is because HFT usually make very little percentage of profit each time but create huge total trading volume and very high trading frequencies, and at the same time supposedly lowering trading cost for the whole marketplace because the trading time and bid-offer spread are shrunk.

Opponents focus on several perceived issues with HFT. One of the largest issues often cited is that HFT traders manipulate market price with their trading. Leveraging a faster trading speed than usual manual traders to create and cancel large numbers of fake orders, HFT traders can potentially mislead other investors and monopolize order processing capabilities.

Another problem is the possibility of creating market volatility. In the US, the Flash Crash in May 6, 2010 is notable as well as the Chinese fat finger accident of Everbright Securities in August 16, 2013. Breaking news which can trigger reactions from algo-trading systems, sometimes leads to huge fluctuations in market prices and can lead to huge losses for some disadvantaged investors.

There are solutions to solve the highly speculative behavior of HFT. One method is to raise fees on canceled orders. The second method is to raise taxes or fees on trading volume, for instance, setting a tiered tax ladder.

High Frequency Trading in China

High frequency trading in China has developed quickly since the release of the CSI300 index futures in 2010, but Chinese trading companies still have a relatively conservative attitude towards HFT as compared to their peers in the west. There are some barriers for the wider application of high frequency trading in China's capital market. Firstly, the SSE market trades on t+1 settlement, which makes HFT impossible. Further, even in the financial futures market, as HFT traders usually have very high requirements for pricing data, demanding millisecond precision, the local futures exchanges cannot reach the technical requirement of most HFT firms. In addition, as Chinese regulators and supervisors are more concerned with the needs of retail investors over institutional, HFT may not be too welcomed at all. Furthermore, Chinese capital market is extremely speculative, the high-frequency trading may not be successful in Chinese market as in the west. Finally, the high trading fee raised by local securities companies and futures companies could prohibit any significant HFT behavior in the market.

In the future, high frequency trading in China will only develop as more assets come to market and as trading restrictions and costs lower. The introduction of low-latency technologies for traders and exchanges might help China to increase the proportion of HFT in the total trading volume. By the time that happens though, the debate in the US might already be settled with HFT taking a much smaller role and likely limiting its future in China as well.