Proprietary trading firms (prop firms) play an integral role in the life of a trader as they provide the necessary capital to implement their plans. These firms have created a way for capable traders to take advantage of changing prices in the market without employing any of their own risk capital. Nevertheless, these firms do not accept all trading strategies, particularly high-frequency trading (HFT) strategies. Although many markets utilize HFT, certain prop firms, including the top prop firms, have chosen to restrict this trading style. To comprehend that, it is necessary to explain the mechanics of HFT, its market implications, and the functioning of prop firms.
What is High-Frequency Trading?
High-frequency trading (HFT) is one of the most recent and fastest developing sectors of trading, often regarded as a subcategory of algorithmic trading. HFT involves the placement of a large number of orders within a fraction of a second to capitalize on instantly available opportunities. Powerful computer systems with designed algorithms monitor the market and execute trades in nanoseconds. The strategy tries to take advantage of small price changes that happen frequently by performing thousands or even millions of trades in a day. Although these trades may seem to yield very little profit per transaction, the grand total can be substantial because of the high number of trades.
The abbreviated time frames and rapid pace of HFT execution require sophisticated technologies like direct market access (DMA) and low-latency links to the exchanges. Market making, statistical arbitrage, and liquidity sniffing are some of the techniques employed in HFT. While high-frequency trading has transformed many aspects of trading, it has created a number of additional concerns, especially in proprietary trading firms.
The Issues High-Frequency Trading Creates for Prop Firms
Here is why some of the top prop firms may choose to outlaw high-frequency trading strategies: The explanation lies within the core structure of HFT and its influence on the traders and the firm as a whole.
1. Manipulative Practices Issues
Perhaps the greatest criticism of high-frequency trading is its possibility of market manipulation. The ability of traders using HFT to move large volumes of orders in a very narrow time frame gives rise to questions of artificial price movements. For instance, some HFT strategies use quote stuffing where market orders that are not intended to be executed are sent in droves. This provides a distorted view of liquidity to other traders which adds to price volatility.
For proprietary trading firms, the possibilities of market manipulation and damage to its reputation are risk factors that need careful consideration. Almost all of the best prop firms strive to maintain moral business practices and refrain from employing potentially manipulative tactics. Even strategies that could reasonably be defended as legal might still be considered unethical trading in some contexts, hence the strict policies some firms impose around trading, including banning HFT.
2. Increased Norm Enforcement
HFT has been increasingly restricted by regulators worldwide. The nature of HFT’s complexity and speed makes it hard for regulatory bodies to keep track. There have been a range of scenarios in preceding years where regulators have raised concerns regarding the part HFT plays in deepening the intensity of market crashes or triggering flash crashes.
Examples of the risks associated with high-frequency trading strategies would include flash crashes such as the one that took place in the U.S. stock market on May 6, 2010. During this period, the market plunged at an alarming rate of over a 1000 points within a few minutes then bounced back up just as quickly. While an array of factors contribute to this totally unstable movement, HFT is certainly blamed for its ill-effect on the “volatile movement”. This led to huge public and regulatory outcry.
To mitigate the aforementioned issues, regulators have begun to implement more stringent controls on HFT. For instance, in Europe, the MiFID II, or the Markets in Financial Instruments Directive, included regulations intended to lessen the effects of high-frequency trading. These regulations entail obligatory resting periods for orders as well as risk management systems for traders.
Such regulations allow proprietary trading firms to operate under their bounds. To steer clear of attention from such overlapping regulatory bodies and reduce compliance burden, proprietary trading firms may adopt an avoidance strategy where they disregard high-frequency trading methods.
3. The Technological Arms Race
HFT activities demand unparalleled technology such as co-location services, which allow traders to set their computers beside the exchange’s servers, to reduce latency. This disparity in technological investment can create a disadvantageous environment where only the well-funded firms outperform the competition, thus rendering the rest as inept. Independent traders or smaller prop firms who cannot afford the necessary resources suffer from a competitive imbalance in the market.
In reference to the best proprietary trading firms that provide capital, their equity and fairness might be problematic. A prop firm without the financial resources to heavily invest in HFT technology would find themselves at a disadvantage. This is the reason for many prop firms, particularly those aimed at retail traders with limited trading capital, to completely avoid HFT. These prop firms eliminate high-frequency trading so that all traders—regardless of their funding or access to technology—compete on equal footing.
4. Greater operational expenses
The cost of running a high-frequency trading operation is significant. The infrastructure required for HFT features high-speed data feeds, ultra-low latency execution platforms, and colocated servers. Additionally, firms must pay for proprietary systems maintenance and improvement to specialized personnel such as quantitative analysts, data scientists, and engineers.
Under the “one step challenge prop firm” model, additional costs become untenable for most prop firms. A one step challenge prop firm is defined as a firm that allows traders to earn capital after completing a challenge that evaluates their trading capabilities. These firms generally tend to devote lesser capital to the business and therefore, require less sophisticated infrastructure. The overhead costs of HFT may not be suitable for the business model of such firms, prompting them to ban the strategy altogether.
5. Risk Management Issues
High-frequency trading or HFT is characterized by executing a large number of trades in a very short time frame. This makes risk management more complicated. The rapid execution of trades makes real-time monitoring and management of positions very difficult, especially in volatile markets. Additionally, the sheer magnitude of the complexity in managing hundreds or thousands of trades in a single day exponentially increases the chances of incurring costly losing trades resulting from technical glitches, a lack of coherent total situational awareness, or system failures.
For those with a “one step challenge prop firm” model, this level of exposure can be quite difficult to bear. Even though the risk is minimized across many trades, the possibility of catastrophic losses is still there if the algorithms or systems fail. Therefore, many prop firms choose to forgo high-frequency trading in order to preserve their capital and reputation.
Managing Creativity and Risk
Even with high-frequency trading’s difficulties, it’s worth mentioning that not all prop firms completely ban HFT. Some of the best prop firms are known to apply algorithmic trading and other creative techniques, but do so in a manner that does not breach laws and acts ethically. These are the firms that have the resources to develop sophisticated systems and execute comprehensive risk management.
For the traders, it’s crucial to know the policies of the individual classes they sign up for, especially with regard to challenges like the one step challenge prop firm model. Even though HFT will most likely not be allowed, many other profit-making strategies exist that are in line with the firm’s goals and risk appetite.
Conclusion
There is little to no doubt that HFT has advanced the finance sector in one way or the other, however, it does present profound risks and difficulties, predominantly for proprietary trading firms. The moral issues, compliance concerns, and technological limitations present challenges that many prop firms are not able to fully adapt to. Those that maintain a responsible and ethical trading environment like the best prop firms or those offering one step challenge prop firm opportunities tend to not embrace high-frequency strategies. Regardless of the type of prop firm, many of them gravitate towards alternative trading strategies due to the expenses and intricacies underlying HFT, despite its potential profitability for certain firms.
