Is High Frequency Trading a technology run amok?

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News of Panther Energy Trading manipulating the commodity markets shows that High Frequency Trading is causing more problems than it is solving and needs to be reformed. Photo: Luis Villa del Campo/Flickr

The analogy between any competitive sport and the cutthroat world of finance works at many different levels. They overlap when it comes to training, but it is in the real world that competition turns into a ‘dog-eat-dog’ proposition.

This makes it sound overly dark and bleak, but the reality of it is more like the desperation seen in the ‘Hunger Games’ series.

One is always looking to make the extra buck, or gain any sort of competitive advantage over the other competitors. The gold medal, or earning that extra billion, seems to be a reason enough to legitimize questionable or illegal methods and the punishments are not strict enough to deter those behaviours.

Since the advent of stock and commodity trading and going digital with the use of computers and technology, it was only a matter of time before software and algorithms were going to take the place of human beings. Complex formulations meant that rather than having a slow human being reacting to the market in his own manner, computers could trade and react to the market in nanoseconds.

This gave rise to high frequency trading (HFT). And as the new method was developed, new loopholes were found in the system in order to make money.

Just like developing more complex locks only makes the lock-pickers more adept, similar takes place in the asset markets. Panther Energy Trading has now been fined $4.5 million by U.S. and UK regulators for using algorithms to manipulate the commodity markets. The system used by Panther allowed them to place and cancel bids and offers for different future contracts in the mercantile exchanges. This was the first time Dodd-Frank legislation was imposed in order to curb manipulative trading activities.

The algorithm allowed Panther to falsely imply a situation that was not yet prevailing. By placing large Buy or Sell orders in the market, Panther was able to imply huge buying or selling interests in the market — which fooled people into thinking that the market had an overwhelming buy or sell interest.

Buy or Sell prices correspondingly became based solely on sentiment, rather than on-the-ground realities.

Imagine that you want to sell your house on the market, and you know that there is only 1 other house like yours, so you want to ask a higher price for it. You get a phone call from your friend then that instead of 1, there are a 1000 houses like yours. This would make you want to sell it at a lower rate in order to get to sell it. The same applies if you are buying a house. Once you see that there are 1000 other people looking to buy the house that you want, the price you would be willing to pay will rise.

Now imagine that the information from your friend just happened to be a rumour floating around.

That is what these algorithms did. They caused the original rumour and spread the rumour around.

This is not the first time that HFT’s have come under scrutiny, and it is likely not the last. In the past huge fines have been imposed on different brokerage and trading houses. The blatant abuse this time has caused an additional one year ban on Panther and there is a push to increase this ban further in order to send a strong message. Gaps and loopholes continue to exist in HFT as regulation of this part of the market is still maturing.

Until full HFT maturity is reached, there will be times when rules are bent and even violated in hopes that they cruise under the regulatory radar. Just like new human growth hormones are always being discovered and used by athletes, traders are also take chances to gain the competitive edge.

© Zain Naeem

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