How does high-frequency trading affect market quality and what should CFA candidates know about it?

High-frequency trading (HFT) refers to algorithmic strategies that execute thousands of orders in microseconds, profiting from tiny price discrepancies. HFT firms use co-located servers (physically close to exchange matching engines) and ultra-low-latency connections to gain speed advantages.

How HFT Firms Operate:

1. Market Making: HFT firms post continuous bid-ask quotes, earning the spread. They adjust quotes in microseconds as conditions change, rarely holding positions for more than seconds.
2. Statistical Arbitrage: Algorithms detect temporary mispricings between correlated securities (e.g., an ETF and its underlying basket) and trade to capture the convergence.
3. Latency Arbitrage: Exploiting the time lag between price updates across different venues — if the price moves on one exchange, the HFT firm can trade on another before that exchange updates.

Impact on Market Quality:

Example: Suppose Kessler Investments (fictional) submits a buy order for 10,000 shares on exchange A. An HFT firm detects this order and, within microseconds, buys on exchange B (where the price has not yet moved) and sells to Kessler at a slightly higher price. This latency arbitrage transfers a small cost from Kessler to the HFT firm.

Regulatory Responses:

• Speed bumps (e.g., IEX's 350-microsecond delay)
• Minimum resting times for orders
• Enhanced surveillance of spoofing and layering

Exam Focus: The CFA curriculum presents a balanced view — HFT improves liquidity in normal conditions but may reduce it during market stress. Understand both the benefits and the concept of 'phantom liquidity.'

Practice identifying HFT strategies in our CFA Level I question bank.