Proponents argue that high-frequency traders provide the necessary liquidity, while opponents raise the flag of the “little guy,” also known as the small-lot investor or retail trader, as being hurt by HFTs. The question is whether the average investor is really a victim of HFT activity when most investors buy mutual funds; Furthermore, the largest mutual funds do not use the exchanges for their large lot orders and are therefore rarely affected by HFT intraday trading on the exchanges.

The question of whether high frequency trading is good or bad for financial markets is not as simple as the news would have everyone believe. The problem and any solutions are as complex as the world of HFTs, which are traded on every financial market in the world.

The roots of high frequency trading come from the day trading floor traders of the 1980’s and 1990’s. The market makers of that time decided to try to squeeze out the growing annoyance of rogue floor traders, who parted ways with their previous employers. on the exchanges to trade independently with the new PC computer that allowed them to trade at home. These independent day traders ushered in a new era of fast entry and exit trading, taking advantage of the wide bid-ask spreads of that day’s fractional pricing structure.

Market makers pushed for a decimal pricing structure believing that tighter supply and demand would eliminate the professional independent day trader and newly minted retail day trader. These traders could see huge lot orders from institutional clients moving through the exchanges, and would preempt huge lot orders that would force the price higher. This infuriated the institutions and market makers who managed those large lot orders on behalf of the giant mutual and pension funds.

Decimal pricing replaced fractions in 2002 and briefly reduced the trading activity for the day, however this was only a brief respite.

By 2005, computers had evolved to provide much faster speeds, and more sophisticated software provided algorithms and formulas that could track orders moving through the system. Without the large spreads, day traders resorted to faster speeds. Faster speeds meant they could trade more frequently even with a penny or a half penny and still make a profit.

HFTs caught on quickly, and the enormous liquidity these companies provided became a very lucrative opportunity for exchanges, which had seen a steady loss of revenue as more, smaller exchanges emerged along with more ECNs. Dark Pools also started taking more and more order flow from exchanges. The Dark Pools were a direct result of HFT trading on the exchanges. Now, instead of large batch orders moving through exchanges, large batches were being filled in Dark Pools. This caused the exchanges to lose more money.

Then, too, the exchanges went public, and as public companies, their objectives and business structure changed drastically. NYSE and NASDAQ needed to make their shareholders happy rather than just provide a great trading experience for their clients. They sought more HFT to fill the void caused by the loss of large lot investors, who were no longer using the exchanges for their millions of shares of orders. HFT activity increased as exchanges offered these companies maker-taker rebates to provide liquidity for exchanges.

HFT activity peaked in 2009, with an SEC-confirmed dominance of 56% of all orders in the stock market at the time. It has been said on various internet sites that it was as high as 77%, but that was ALL automated orders and not just the HFT order flow.

Because HFTs offered liquidity and could trade anywhere, exchanges offered a maker-taker contract with many of the HFT firms. A maker-taker sometimes acts as a market maker, however the maker-taker is not required to “make a market” as a market maker is bound by regulation and law.

A maker-taker is a rebate program designed by exchanges that returns a rebate to the HFT whenever they provide liquidity to the exchanges. HFTs were needed by exchanges to provide liquidity because there was an unexpected negative side effect of switching from fractions to decimals.

With spreads getting tighter, more and more market makers found they couldn’t make enough profit and compete with high-speed computers. Slowly, the market makers on the floor of the New York Stock Exchange disappeared leaving only a few on what had once been a busy and crowded trading floor. Throughout the US, in every stock market and every financial market, market makers began to disappear.

Exchanges lost more liquidity as HFT’s dominance of the stock market increased between 2005 and 2009, leading giant lottery institutions to Dark Pool venues known as Alternative Trading Systems ATS.

The decimals that everyone believed would make markets more efficient had resulted in less efficient markets, a great need for takers to fill the role of declining market makers, and ever-increasing speed of transactions.

Now, the argument about how to regulate and control HFTs is gaining political popularity and, once again, financial markets are at a crossroads. Any change in the way financial markets operate from something that seemed as simple as switching from fractions to decimals creates reverberating impacts that cannot be foreseen, projected, or even understood at the time.

No one in 2002 thought that decimals would lead to a new form of high-frequency day trading. No exchange in 2005 really understood how HFTs would alter not only intraday activity, but also the overall volatility of the markets. No one could have predicted the demise of the market makers who had been an anchor for the market that kept it firm, stable and strong for decades.

The solutions that have been put forth lack a deep insight and understanding of how a small change can have massive repercussions not only for the stock market, exchanges, ATS, and all market participants, but for all other financial markets as well. world level.

HFTs need to be regulated, but their true roles, benefits, issues, risks and areas open to fraud must first be identified. So far none of these have been empirically documented by anyone.