03/29/2013 09:21 am ET Updated May 29, 2013

The Risks of High-Frequency Trading

As a high-frequency trader I often weigh the risks of HFT. Some of these considerations are generated by the obvious desire to contain the risks of my operation and thereby enhance profitability and attractiveness to prospective partners and investors. Alternative concepts are driven by the proposals of third-parties, who are often individuals that view HFT as a threat. In this note I explore the real and the imagined risks from the impact of HFT -- specifically and externally.

As I discuss in my new book, High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems, 2nd Edition (Wiley, ISBN: 978-1118343500), most of the risks specific to HFT fall into three broad categories: trading risks, software risks, and the risk of market manipulation. Trading risks comprise the market and other risks associated with trading operations, both high-frequency and low-frequency. Software risks refer to the mission-critical systematic nature of HFT and measure the risks embedded in technology setup and implementation. The risk of market manipulation is typically listed as the number one concern of non-HFT market participants, who can feel unsettled by an absent in-depth understanding of high-frequency trading processes. Each of these three categories of HFT risks could spill over, to the detriment of other parties. For example the risk of HFT market manipulation may affect other HFTs, while the trading risks and software risks have the potential to destabilize the overall markets.

While many risks of HFT market manipulation are overblown, selected risks are existent and certainly real. Take, for example, the risk of "spoofing." This illegal activity briefly distorts the shape of the limit order book, with the explicit goal of misleading other traders of all frequencies. They are misled about the supply and demand of financial instruments available in the markets and, as a result, about the impending movement of the markets. The causes and effects of spoofing are similar to their low-frequency counterparts, seen in market manipulation activity such as pump-and-dump and bear raids. While both the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodity Futures Trading Commission (CFTC) have already successfully identified and prosecuted spoofing offenders, detection of spoofing remains complex, limiting the agencies' ability to catch the perpetrators. In my upcoming courses on HFT, I discuss some of the models potentially suitable for identifying spoofing.

The trading risks of HFT may decimate the HFT operation and at the same time greatly affect other market participants. Particularly, in selected markets, unchecked HFT may quickly incur considerable losses, well in excess of any tolerable limits. While such losses will first and foremost affect the HFT itself, the instability of the HFT can wreak havoc in the markets through its capacity as a counter-party to other traders. Many strategies for mitigating such risks exist which I discuss in my new book.

Last but not least, poorly managed technology can be a killer of not just HFT operations but markets as a whole. Take a Knight Capital fiasco which occurred on Aug. 1, 2013, where within 45 minutes the once-powerful firm was reduced to ashes. If the Knight trading algo errors were resonated by other errors in coding of exchanges, or other market participants, the errors could potentially shut down entire markets and wipe out trillions in values from various sources. Luckily, procedures for creating mission-critical systems are well established and understood by qualified professionals. Following the necessary step-by-step development and testing procedures, however, can seem overly arduous to financial services executives unfamiliar with such technology. The chosen shortcuts may then lead to disastrous consequences, while the thoughtful compartmentalized approach to HFT development ensures stable systems that bring only positive externalities to the markets and their investors.

In summary, HFT is fraught with risks, yet most of these risks are known and can be successfully managed. Whether internally within an HFT operation or externally to it, all traders and investors can take active steps to build or buy solutions which are designed to minimize their exposure to undesirable HFT features in the markets.