Higher Frequency, Lower Risk

High frequency trading has generated awe in some and consternation in others. This innovative trading technique uses computer-generated signals to turn over capital at a rapid pace. The detractors claim that high frequency trading has a very risky profile and is capable of destabilizing the markets.

But here I examine the risks of high-frequency trading in comparison with lower-frequency trading styles across every risk category defined by Basel II, the international risk management standard: Market risk; Credit and counterparty risk; Liquidity risk; Operational risk; and Legal risk.

The key findings being that high-frequency trading strategies are considerably less risky than traditional low-frequency trading in market risk, credit and counterparty risk, liquidity risk, and operational risk categories. In the legal risk category, high-frequency strategies are as risky as low frequency trading.

Market risk measures the financial impact of potentially adverse price movements of traded securities. In a low-frequency setting, much of the market risk comes from extreme events caused by or leading to a market disruption. Such risks are also present in a high-frequency setting, yet are much smaller. Rapid turnover of capital means that the per-trade losses are limited.

In addition, the trading systems do not incur any overnight market losses characteristic of low-frequency systems. Such overnight losses often result from the traders’ inability to react promptly to news when the markets are closed.

Second, credit and counterparty risk measures the ability and intent of the trader on the other side of the transaction to uphold his obligation. This risk is particularly pronounced in bilateral over-the-counter (OTC) trading. In high frequency trading, much of trading is done on exchanges or within pre-approved networks (inter-dealer or dark pools), where the counterparty risk is taken on by the settlement firms. As a result, credit and counterparty risk is less significant in high frequency trading than in low frequency trading.

Third, liquidity risk is the ability of the trading operation to quickly unwind positions. By design, high frequency trading systems operate only in the most liquid markets, with readily available buyers and sellers, thus minimizing risk.

Fourth, operational risk covers the efficiency of daily trading operations. In low frequency trading, most procedures can be detailed and followed up on over extended periods of time in order to minimize potential missteps, yet the operational risks remain high: human traders can fall ill, forget the instructions, or be overcome with emotion. In fully computerized high frequency trading, these issues are eliminated: the computers are thorough at following instructions.

Other issues, like technology maintenance and supervision, become more prominent in the high frequency setting. Solutions for managing risks created by these systems have long been developed. Finally, legal risk of trading encompasses all risks associated with contract execution and enforcement. As such, it tends to be independent of the trading frequency.

Overall, high frequency trading is a profitable, lower-risk endeavor that has been revolutionizing the markets and lowering trading costs for traders of all frequencies. The technology-induced savings have been passed on to the end consumer: an individual investor either capable of executing his trades cheaper in the markets or getting higher shareholder returns on his banking investments.

About the Author

Irene Aldridge is a Managing Partner, Able Alpha Trading, LTD. She is also the author of “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems,” published by Wiley Trading and available for pre-order on Amazon.com.