The Next Flash Crash Awaits: Why High-Speed Trading Is Still a Huge Threat

Flash Crash 2010
Flash Crash 2010

In 2010, when the Dow Jones Industrial Average suddenly dropped 600 points and then just as quickly recovered -- the so-called "flash crash"-- high-frequency trading, or HFT, became the new economic bogeyman: hiding in a dark corner of financial cyberspace, waiting to jump out and wreak havoc in the markets.

But just as quickly as HFT became infamous, and the subject of intense debate in government and the press, it crept back into the shadows.

An upcoming report from the Commodity Futures Trading Commission may change all that and put HFT back into the spotlight where it belongs.

Trading at Inhuman Speeds

HFT works like this: Powerful computers use complex programs to execute a large number of market orders extraordinarily fast. The algorithms in these computer programs go out to multiple markets, analyze them, and execute trades according to previously encoded parameters -- all by themselves, in a split-second's time, without a human at the helm to check to make sure everything's going smoothly.

Currently, 60 percent of all trades on U.S. stock markets are executed as high-frequency trades, and therein lies the danger: With the majority of equity trades now done by mindless computer programs, there's the potential for runaway, market-crashing errors.

This is precisely what happened in the flash crash on May 6, 2010.

According to the Securities & Exchange Commission, a mutual fund started running a trading program near the end of the trading day to sell $4.1 billion of futures contracts, which dumped 75,000 contracts into the markets over a period of 20 minutes. Normally, that's how many contracts would be moved over a period of five hours. High-frequency traders quickly snatched up these contracts to start doing deals with, which in turn caused the mutual fund's program to accelerate its selling.

This frenzy of buying and selling in the futures market then made the jump to the stock market, causing the Dow to briefly -- but terrifyingly -- plunge.

Follow the Fast-Moving Money

The upcoming CFTC report might reignite the debate surrounding HFT. It focuses on futures contracts, specifically, the kind that bet on the future value of the S&P 500.

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The report finds that, due to the practice of HFT, small traders are losing an average of $5.05 per trade on S&P 500 futures contracts, a very popular and widely used kind of financial contract.

While $5.05 may not sound like much, when you multiply that by millions and millions of transactions, it's big money. And while it is retail investors who are being hurt the most by HFT, brokerages and pension funds -- the big institutional traders -- are also being hurt, which could affect the performance of 401(k)s, IRAs, and defined-benefit retirement funds.

A Potentially Not-So-'Flash' Crash

Defenders of HFT make the argument that the practice injects liquidity into the market, which can help the markets if they get stalled (that is, when buyers or sellers can't find parties to take the other side of the trade).

But even the defenders of high-speed trading acknowledge the lurking dangers. Professor John Beddington, the U.K.'s chief science advisor and author of a report claiming HFT is mainly beneficial to markets, says: "There's a real potential for feedbacks [sic] between computer programs to exacerbate fluctuations in trades."

HFT certainly seems to be picking the pockets of both institutional and retail investors, and that's a problem, because it could hurt the integrity of the markets. But that's small potatoes compared to the kind of real damage HFT could wreak in conditions similar to those surrounding 2010's Dow plunge, damage that -- with 60 percent of all trades now being made as HFT -- may not be over in such a flash.

John Grgurich is a regular contributor to The Motley Fool.