If you are looking to dip your toes into the world of investing during these last few weeks of summer, it is important to consider which exchange, market, and tools you want to use to increase your chance of success. In making these decisions, you may be concerned about running into High-frequency traders, the individuals primarily responsible for the volatility that plagues the stock market. If you opened up a portfolio right now to invest your savings, could you plausibly find yourself at a disadvantage as an amateur investor, or does the impact of HFT only preoccupy major economic actors? 

While independent novice investors would be subject to market swings created by HFT, some reforms have been introduced to allow them to trade more at ease. Rather than having a direct effect, reform works in a trickle-down manner. This means that amateur investors may not immediately feel the effects of HFT reform but will instead trade in a market that has been shaped to eliminate these high-speed competitive practices, according to Eric Budish, ​​Steven G. Rothmeier Professor of Economics at the University of Chicago, Booth School of Business. Reshaping the market’s design to promote deconsolidation “would level the playing field between the very most sophisticated HFT participants and the next tier of sophisticated market participants,” which could include firms that use algorithmic trading, said Budish. This then ends up “benefiting other investors because the market is more liquid,” including those who may have just started a career in investing. 

The correlation between market reform and liquidity is very straightforward. I previously covered how High-frequency traders claim that they are increasing liquidity with the amount of transactions that they oversee, but in reality, certain new approaches to structuring the market would do a better job since they remove the volatility of HFT. 

One solution, proposed by Eric Budish, Peter Cramton, and John Shim in their paper, “The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response,” argues that our approach towards time should be reoriented when trading on the market. Instead of treating time as a continuous variable, making it so that orders are processed exactly in the order they are received, the trio proposes “discrete-time trading,” wherein a trading day is divided into time intervals or batches, and requests received during the same interval are assessed simultaneously. The system increases liquidity since traders are no longer “worried about being a billionth of a second too slow,” said Budish, which would encourage them to trade more due to an increased feeling of protection.

This increase in liquidity would be followed by a chain effect where you might feel more comfortable investing even as a neophyte. Top High-frequency traders would lose their edge over second-tier sophisticated economists since each billionth of a second would no longer be seen as economically valuable and competition would soar. When second-tier traders benefit, their clients with slightly less sophisticated tools do as well. This process continues through a sort of domino effect. Even if novice investors are at the very end of this chain, they will feel the beneficial effects of a less volatile system.

The discrete-time trading approach that Budish, Cramton, and Shim advocate has slowly found its way into novel exchanges. However, as previously discussed, special interest usually inhibits drastic changes from actualizing. The European Securities and Markets Authority (ESMA), for example, has introduced certain elements of frequent batch auctions (FBAs) without fully taking advantage of their benefits. To reiterate, an FBA is essentially when a group of requests is assessed collectively, treating time as a discrete instead of a continuous variable. Currently, European markets call for an auction every time a pair of opposing orders can be matched or upon the submission of an order, stopping short of creating definitive units of time that would eliminate the frantic millisecond rush that preoccupies High-frequency traders.

HFT’s effects and the difficulty of accessing smaller exchanges that address certain elements of this process may be dissuading you from trading on the stock market. You may also be hearing about bitcoin more often and have an interest in engaging yourself in crypto exchanges. Bitcoin exchanges, of which there are many to choose from, are explicitly separate from the traditional stock market. Could you avoid falling prey to the economic nadirs that HFT entails by focusing on bitcoin or ethereum? Has the crypto market still not been impacted by HFT?

A few years ago, the answer would have been yes, but recent corporate expansion and the introduction of colocation to cryptocurrency firms have encouraged HFT to spread to the bitcoin market as well. Colocation refers to the process whereby a client’s server is strategically placed in the same physical location as his or her chosen exchange, allowing trades to be executed hundreds of times faster. Sounds familiar, right? Just like traditional investment firms, crypto companies are also abusing the advantages that come with physical proximity to give their clients the upper edge.

Another way in which High-frequency traders are taking advantage of bitcoin is through arbitrage, a process by which buyers try to exploit price differences between multiple exchanges in order to make a profit. Since there is a multitude of bitcoin exchanges, the possibility of successfully taking advantage of price disparities increases. HFT traditionally targets “either the same asset trading in lots of different venues or a highly correlated asset trading on lots of different venues,” according to Budish. Bitcoin satisfies these criteria impeccably.

Consequently, High-frequency traders have not hesitated to encroach upon the crypto market as well. “What’s so great about bitcoin if you’re a HFT is there’s a gazillion crypto exchanges,” added Budish. “If you’re a High-Frequency Trader, you love inefficient markets [and] you love complex markets. Inefficiency and complexity means more open space to feast.” These sophisticated traders don’t even need to believe in the future of bitcoin. The currency has a high volume and is easily tradable, which is enough to execute arbitrage without investing long term in the future of bitcoin. Even if you think that you might be avoiding the swings of HFT by investing in bitcoin, the problems remain relatively similar, unfortunately. And of course, celebrity influence continues affecting the price of bitcoin and increasing volatility, which may be undesirable for first-time investors.

This research should not discourage amateur investors from participating in the stock exchange. HFT has existed in traditional markets for over a decade, and while this presents certain risks such as unpredictable flash crashes, you will probably not feel any direct impacts from the process. The omnipresence of HFT is what we should be more concerned about. Its recent spread to crypto markets, including ethereum and bitcoin, is problematic since these exchanges don’t have regulatory institutions capable of introducing change. The discrete-time solution to HFT articulated by Budish’s team may have a harder time being accepted in crypto markets, though the entrepreneurial energy and innovation of bitcoin traders could allow for easier implementation. 

In any case, certain solutions which reimagine the way that markets function should be considered by major exchanges like the SEC. Transforming time from a continuous variable to a system where frequent auctions are held and processed with groups of orders would eliminate the millisecond race that High-frequency traders seek while also spurring competition. While such solutions may be scorned by special interests that presently dominate the market, support from ordinary investors could allow these creative solutions to start seeing more implementation in alternative exchanges before making their way to mainstream markets.

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