NCPA - National Center for Policy Analysis

In Defense of High Frequency Trading

September 23, 2016

Washington recently put Wall Street back into its crosshairs when Representative Peter DeFazio (D-Ore.) introduced a bill to levy a 0.03 percent tax on transactions involving stocks, bonds and derivatives. His goal is to reduce "speculative financial trading" and to "curb near instantaneous high-volume trades that create instability in the stock market and in our national economy." Democratic presidential candidate Hillary Clinton advocates taxing high-volume or High Frequency Trading (HFT). This market activity has been under scrutiny since the Great Recession, and especially since the "Flash Crash" of 2010; but, is high frequency trading really to blame for market crashes?

What Is High Frequency Trading? High frequency trading uses highspeed market data and analytics to find small, short-term price differences signaling supply and demand opportunities. These price fluctuations are often the product of predictable behavioral or mechanical characteristics of financial markets. To receive market data as quickly as possible, stock brokers that specialize in electronic trading use advanced algorithms, on high-speed computer systems, in offices close to an exchange -- such as the New York Stock Exchange.

The algorithms allow computers to execute buy and sell orders electronically when a security's price fluctuates. Usually these transactions are executed in microseconds, and the profit is just a cent or a fraction of a cent, per transaction. For example, a firm might buy a stock that is selling for $20.00 on the NYSE, and simultaneously sell it on an exchange in Chicago where the price is $20.01. The firms execute enough of these transactions to make hundreds of thousands of dollars per day.

However, this type of trading is not an exotic activity; 90 percent of personal investors have access to high frequency trading, either directly or indirectly, through their broker.

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