High-frequency trading is changing the markets as much as any of the myriad of regulatory and economic changes that are underway. This is changing liquidity and trading strategies for the increasing number of firms that employ it.

High-frequency trading (HFT) — sometimes colloquially called "hi-freq" — is the automated trading that takes place when sophisticated computerized tools allow firms to trade stocks or options. And, as much as any of the numerous other regulatory, economic and technological changes taking place in futures markets today, high-frequency trading is changing the way that trading firms operate.

In the past several years, some pace-setting firms, such as Infinium Capital Management, are starting from the get-go trading in an automated environment. The Chicago-based trading firm was founded in 2001 "with the mission to pioneer electronic trading of exchange-listed options and futures as the market evolved toward screen-based trading," according to Aaron Lebovitz, a principal of Infinium. "We began trading in automated fashion once our platform was built in 2002."

At its heart, high frequency allows for lower-latency trading, reducing the time it takes to execute a trade from minutes or seconds to micro-seconds, and allowing trading firms to place more short-term strategies, and ultimately "increasing the liquidity and arguably increasing the compression in spreads," according to Sang Lee, managing director at Aite Group, a leading research firm for the financial services sector.

Case in point: Infinium Capital utilizes a combination of human and automated trading, depending upon the issue, according to Lebovitz. "The types of activities we have invested in automation involve the simpler products, such as futures and vanilla option structures," he says. "We currently do, and will continue to, integrate those electronic trades with our activities in more complex or less liquid products such as deferred futures expirations and complex option structures."

While this technology favors more liquid issues, as Lee points out, smaller, more tech-savvy shops can benefit from high-frequency trading, even in the short run.

"I think it’s made the market more competitive," says Lee."Smaller firms that make the technology investment can effectively compete against larger firms. It’s leveled the playing field."

The usage of high frequency, by most accounts, is snowballing. For example, automated trades accounted for almost two-thirds of CME Group foreign-exchange futures volume in the second quarter of 2011.

Since implementing an HFT system can be expensive — costing upwards of "hundreds of thousands of dollars," says Lee — Lee believes that it is unlikely that high-frequency trading would ever be employed by all trading desks. Investment firms that deal in less liquid equities, or that employ more of a buy-and-hold strategy, he says, may feel little need to sink the money into this technology.

Part of a Broader Change

Ultimately, it is not high-frequency trading in isolation that is shaping the equities market. High-frequency trading is having a more profound effect because it is working in tandem with other on-going regulatory and technological factors that are also enhancing liquidity and a greater emphasis on speed and narrowed spreads across asset classes, according to Lee. Cases in point: The introduction in recent years of the FIX protocol, a standard for expressing algorithmic orders used by virtually all broker-dealers as well as banks and funds and institutional investors; and the growing popularity of co-location services that allow trading firms to place multiple data centers close to trading centers.

"It would be tough to argue that we’ve ended up where we are just because of high-frequency trading," Lee notes. "In the end, all these factors reinforce each other."

Nonetheless, Lebovitz believes that high frequency is contributing to making the markets more stable, transparent and efficient. "We believe that all of our market making activities reduce market volatility and reduce customer trading costs by adding to the depth of markets, by increasing transparency of prices, and by tightening bid/offer spreads," he says.

A recent study commissioned by the British government’s Office for Science supports Lebovitz’s view. In its study of the HFT impact on liquidity, transaction costs and price discovery, it found that "overall, liquidity has improved, transaction costs are lower and market efficiency has not been harmed by computerised trading in regular market conditions."

And high-frequency usage is broadening throughout the trading world, as well as deepening in various sectors. "There are hedge funds that are quietly launching high-frequency desks," Lee says. "As the market continues to mature, you’ll see more of a framework of controls around high-frequency trading." Indeed, he says that the next group to embrace high-frequency trading may not be the small trading firms, looking to gain advantage on their larger counterparts, but may in fact be the larger and more traditional trading firms as well.

Infinium, like other trading firms, has taken several steps to ensure that high-frequency trading does not create a more turbulent market, according to Lebovitz. The firm works closely with both industry organization and with regulatory agencies to develop guidelines and detailed best practices for firms that engage in automated trading. They have also adopted "a philosophy of ’multiple, redundant checks,’ whereby our individual trading algorithms each have bespoke monitoring of their activities to provide the most targeted protections," he says.

For example, Lebovitz says that many of Infinium’s algorithms will shut themselves down if they trade at a price significantly different from the order price, because that would indicate that the algorithm may have miscalculated where the market is currently trading. The redundant checks are introduced outside of the individual strategies, where the firm has software components that monitor messaging and fill patterns of individual algorithms out of band (in separate applications residing on separate hardware). He adds that the firm has several of these types of checks to address any identified points of failure in the system.

In the case of the infamous ’flash crash,’ Lebovitz points out, "Infinium did continue to provide liquidity in many of the products we trade all the way through the volatility. I think that our activity along with that of many other automated trading firms contributed to the stabilization and ultimate rebound of the market that day, quite the contrary to adding to the turbulence."

In the end, Lee believes that the need for speed will continue to drive forward markets and the technology that supports trading. More regulatory rules that move the equities market toward "greater transparency" — including better reporting of dark pools, or more consolidated audit trails — are likely to follow, he believes. But, he adds, "Arguing whether high-frequency trading is good or bad is a futile exercise. It’s here."