The Effect of High Frequency Trading Systems on Financial Markets

1421 Words 6 Pages
Whilst liquidity plays a central role in the functioning of financial markets, it is volatility that can be truly detrimental. Despite almost universal agreement among academics that HFT improves prices for investors and dampens volatility in equity markets, since the 6th of May 2010 the sector has come under intense scrutiny from regulators.
On a day described as the ‘Flash Crash’, the U.S stock market experienced one of the most severe price drops in its history. In the matter of five minutes, the Dow Jones Industrial Index declined by 900 points, and then recouped the balk of those losses within the next 15 minutes. This unprecedented and unexplained volatility has fired public debate ever since.
In the aftermath of the US ‘Flash
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Market participant Getco, one of the largest HFT firms, argues in a letter to the SEC that the firm actually commits more capital and provides more liquidity during volatile periods, thus supporting market stability when it is most needed (Grant, 2010). On top of this, an independent study (Makan, 2011) led by Andrei Kirilenko, chief economist at the Commodity Futures Trading Commission, found HFTs were actually less likely to exit the market during the US ‘Flash Crash’ than traditional market-makers. Furthermore, a study commissioned by the UK government concluded “Economic research thus far provides no direct evidence that high frequency computer based trading had increased volatility” (BIS, 2011).
However, against this tide of academic consensus, Professor Frank Zhang of Yale University (2011) concludes “Events can move markets, but high-frequency trading increased the volatility in the overall market”. Regardless of being commonplace among academics and experts that HFT provides some extra liquidity for the market, Zhang suggests that high-frequency traders are in fact largely trading with each other, and not providing any liquidity for traditional investors. Additionally, he finds evidence to suggest that HFT causes stock prices to over react to news about fundamentals, and because this over reaction is subsequently corrected, he believes it delivers direct evidence to support HFT

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