Could Speedier High-Frequency Trading Prompt the Next Market Meltdown?

High-frequency trading (HFT) is already lightning fast, but there is currently a proposal on the table to make it even speedier. What are the potential advantages and drawbacks of this possible change? Would faster HFT increase the efficiency and liquidity of markets, or would it yield greater odds of contagion, potentially resulting in the next financial disaster?

In a minute, to offer some clarity for risk managers, we’ll examine both sides of this important debate. But first we need to provide some background about how we arrived at this stage.

Earlier this year, a group of high-frequency traders, market makers and service providers calling themselves the Shortwave Modernization Coalition (SMC) petitioned the Federal Communications Commission (FCC) to use the shortwave band of the radio spectrum to send data between major financial sectors faster than the higher-frequency signals used in fiber optic or satellite transmissions.

Public comments show a well-financed, professional application by the SMC. The band the SMC wants is currently used by several niche technical applications, as well as by amateur transmitters like citizens-band radio and ham radio.

While many current users don’t like the idea of letting high-frequency traders in their domain, they do not appear organized or well-financed, and their objections seem speculative compared to the slick, professional study claiming HFTs will not interfere with current users. So, while I’m no expert in FCC deliberations, my amateur guess is this will pass FCC muster.

Efficiency vs. Contagion: Dueling Perspectives

The SMC makes the controversial claim that using shortwaves will make markets more liquid and efficient. Shortwaves will speed transmission of data between exchanges, which will make the global financial system more “tightly coupled.” But whether this is a good or bad thing is highly debatable.

In his best-selling book, A Demon of Our Own Design, Richard Bookstaber argued that tight coupling is precisely what causes financial disasters. The problem, the author explained, is that, in such an environment, one event “immediately triggers the next, which triggers the next, and things spiral before anybody can intervene.”

For example, imagine an old-fashioned assembly line in which products were on a single conveyor belt that brought them to a sequence of workers, each of whom did exactly one thing. This is tightly coupled because if any worker has a problem, the entire assembly line must be shut down until it is fixed.

In a loosely coupled system, you might put the products on carts that move from worker to worker, and wait in queues of, say, a dozen items at each station. In that environment, an issue with one worker won’t cause a systemic problem – unless it lasts so long that the downstream station’s queue empties, or unless the problem station’s queue overflows. This gives time for the issue to be resolved and for backlogs or shortages to be addressed.

Aaron Brown

This analogy also applies to financial markets. In today’s more loosely coupled HFT market, for example, it might take a tenth of a second for trading in Chicago to affect trading in London. That’s not just transmission delays but time taken for information to be decrypted and integrated into the databases that drive trading. Contagion from a flash crash or system failure or credit collapse or other problem in Chicago is therefore not immediate.

That would change under a tightly coupled market. Indeed, one could argue that if the SMC cuts HFT transmission times from a tenth to a twentieth of a second, that could make things worse, not better.

A tenth of a second isn’t much for humans, but computers can do a lot of processing in that time and circuit breakers, fail-safes and other precautions can kick in to stop local problems from causing global collapses. Moreover, faster transmission works in both directions — a problem in Chicago could cause issues in London, which could spread to other places, and flash back to Chicago to interfere with efforts to clean up the original issue.

On the other hand, in a loosely coupled HFT market, it’s also possible to have problems that arise because places are out of sync.

The SMC might be right that speedier data flows will be better. They just don’t seem to have studied the question carefully.

Capacity, Reliability and Security Concerns

Shortwave transmission comes with disadvantages.

The first is low bandwidth: you cannot transmit complete order books, only simple signals like, “The Fed raised rates 0.25 basis points,” or “Apple stock just dropped 3 points.”

The second is unreliability. There’s a lot of noise in the spectrum from natural radio sources, so signals get lost, and you must keep shifting frequencies to find a clear path. Commercial vendors claim 85% reliability, but my personal experience suggests that’s optimistic.

Last, but certainly not least, is security. It’s cheap and easy to intercept the shortwave signal, and the low bandwidth makes sophisticated encryption impractical.

Nevertheless, service providers have been working under an experimental authorization by the FCC since 2020 and claim to have solved these issues. Their SMC customers seem to agree. 

HFT Evolution: The Ongoing Need for Speed

Before we delve further into the potential consequences of faster HFT for risk managers, let’s talk a bit about basic physics – and then tie this back to the history of HFT and the change the SMC is seeking.

Radio frequencies are measured in hertz, or cycles per second, and frequencies from three to three trillion hertz are used commercially. Low-frequency waves require less power and travel farther before attenuating, but they carry less bandwidth. So, low frequencies are good for sending a little data a long distance, and high frequencies are good for sending a lot of data a short distance.

The Pentagon can use three hertz to make sure its worldwide network of submarines is okay; a medical imaging device, on the other hand, might use three trillion hertz to get a 3D image of your body inches away from the transmitters.

The SMC has its eye on a medium band from two million to 25 million Hertz. This can bounce off the ionosphere above and the surface below to send information far over the horizon.

Radio signals in this band can connect Chicago with Shanghai without the relay stations needed for higher-frequency signals or the delays caused by the glass in fiber-optic cables or satellite transmission systems. This can mean savings on the order of 50 milliseconds — or one-twentieth of a second — over transcontinental transmissions.

In the first decade of HFTs, from the mid-90s to the mid-2000s, people fought over microseconds — millionths of a second. In those days, HFTs operated on single exchanges, and co-located their servers with exchange servers. Having your cable a few feet shorter than the adjoining server’s cable could mean you got the trade and the other HFT didn’t, even with signals at the speed of light.

After 2008, however, market-making HFTs increasingly got interested in cross-exchange trading — using data from Chicago to make trades, for example, in Frankfurt and Shanghai. The struggle in this domain is in milliseconds, not microseconds. Enormous expense has been undertaken to shorten transmission times, and the SMC is the latest chapter in that effort.

Parting Thoughts

What are the potential outcomes of speedier HFT? There seem to be three possibilities.

The benign view is some HFTs will pay for shortwave transmission and grab some money from firms that don’t make the investment, leaving markets basically unchanged but slightly more efficient and faster.

A middling view is shortwave transmission will increase liquidity in the sense of faster execution for end-investors at smaller stated bid/ask spreads, but will also incur high total transaction costs due to unfavorable market movements.

The sky-is-falling view is that tighter coupling of financial markets will cause the next financial meltdown.

I have no strong opinions on the subject, but it would be nice if the people asking for this change, and the regulators considering it, had such opinions and told us why.

Aaron Brown worked on Wall Street since the early 1980s as a trader, portfolio manager, head of mortgage securities and risk manager for several global financial institutions. Most recently he served for 10 years as chief risk officer of the large hedge fund AQR Capital Management. He was named the 2011 GARP Risk Manager of the Year. His books on risk management include The Poker Face of Wall Street, Red-Blooded Risk, Financial Risk Management for Dummies and A World of Chance (with Reuven and Gabriel Brenner). He currently teaches finance and mathematics as an adjunct and writes columns for Bloomberg.