Doug very kindly made a detailed comment to my post about optimal levels of friction in markets which I have been meaning to reply to for a while.
Broadly my take on HFT is that it produces poor quality liquidity – there when you don’t need it and gone when you do – and that if the predominance of trading is bot vs. bot at high frequency, then the dynamics of the market can change in bad ways, witness the flash crash. Doug makes me think twice, though, about some of this, so let’s look at some of what he has to say.
Well if you’re looking for academic literature that tries to identify what’s the best point between very frictional markets and HFT, you might first want to find academic literature that confirms your belief that HFT is bad to begin with. On this front most acaedmic studies tend to find 1) HFT broadly reduces trading costs, 2) HFT increases market liquidity, 3) HFT reduces intraday volatility by filtering trading noise.
It is (3) that I find surprising. It’s relatively straightforward to find definitions of trading costs and liquidity such that (1) and (2) work. I would argue that HFT has reduced trade sizes and decreased liquidity/increased costs for block trades, especially combined with the move to trading the VWAP rather than brokers taking on blocks as a risk trade, but (3) really gives me pause for thought. Is it true?
Well, it depends. If you look at short term (a few seconds) big swings, then HFT has clearly made things worse. See here.
Moreover, HFT activity is correlated with volatility: see here.
Finally HFT seems associated with an increase in autocorrelation of stock returns: see here.
Even without this, there are reasonable concerns that (in the words of the Bank of Canada Financial Stability Review):
Some HFT participants to overload exchanges with trade messaging activity; use their technological advantage to position themselves in front of incoming order flow, making it more diffcult for participants to transact at posted prices; or withdraw activity during periods of pricing turbulence
Then of course, turning back to Doug, …
… there’s the Flash Crash. It’s hard to determine though what the total amount of economic damage from it was. Arguably the August 2007 quant meltdown disrupted more economic activity by causing less displacement from fair value but over a more prolonged time period. So it’s hard to tell if the more frictionless HFT is more disruptive than older inter-day stat arb (which to a large degree it’s supplanted).
Overall HFT firms hold very small portfolios relative to their volume, because of very high turnover. E.g. a typical first-tier HFT group might run 5-10% of US equity volume while having maximum intraday gross notional exposure of $1 bn or less (with much less overnight). Even if 5 HFT firms with perfectly correlated positions simultaneously liquidated their portfolios, it would generate less order flow than the unwinding of a mid-sized hedge fund. The fat finger order that catalyzed the flash crash (75k ES contracts), was simply too large a position to be held by any HFT desk.
Which isn’t to say that the changes wrought by HFT and electronic trading didn’t have anything to do with it. Once the market gets used to a certain level of liquidity it becomes very painful to take it away. Traders will continue to try trade at the same order sizes while market makers provide much less liquidity. The same order flow magnitude will lead to outsized market impact and extreme swings. This is clearly what happened in the flash crash, when quoted size per level on many names went from quantities of 10,000 to 50 or less. Clearly this is less of a problem in an old-school dealer or specialist market.
if the market makers stop or hold off on quoting people on the phone for 90 seconds to figure out what if anything is wrong with P&G it doesn’t lead to market panic. But if electronic market makers pull their quotes for 90 seconds, a lot of people are going to keep trading through those thin quotes and you’re going to get insane $0.50 trades hitting the tape. Of course everyone responds to that and panics, potentially triggering margin calls, etc.
Exactly. My recipe for HFT is not to withdraw it, but to reduce the impact of its speed by (1) requiring all market participants to trade on a central order book – no dark pools and (2) requiring all quotes to be good for a minimum of half a second. This would affect real trading activity very little while completely wrecking the high frequency strategies that generate flash crash risk.
Doug makes an interesting claim though:
However given that the new paradigm of electronic trading has only failed to deliver the liquidity expected of it by the broad market for 20 minutes in the six years since Reg NMS I’d say that it’s a fairly good record. That still means 0.99995% of the time investors reaped much lower transaction costs. And basically unless you yourself were either A) an intraday trader, or B) a levered investor whose broker used intraday positions to calculate margin, you were unaffected. The buy-and-hold retail investor doesn’t care if the P&G he owns temporarily goes to 0 for 3 minutes.
Well, it was more like 30 minutes I think, but anyway the claim deserves analysis. If HFT really lowered bid/ask spreads, then perhaps a once in six year flash crash is an acceptable price to pay for that. Scary though the flash crash was, Doug is right, it did very little direct economic damage. One might argue that it did quite a bit of indirect damage in reducing confidence in markets, but that is a pretty woolly claim. No, Doug’s point is a reasonable one and it deserves further analysis.
I’d say the stronger argument against frictionless markets in general and HFT specifically is that it’s social benefit is small relative to its private profits. If you consider the actual purpose of the financial markets, to allocate capital efficiently, a good metric is the total amount of dollars you add to your portfolio’s return. HFT firms earn high profits relative to this because their low risk and high returns allow them to basically need no outside capital. 100% of the trading PnL beats the standard hedge fund 2/20 or the long-only <1% management.
...The real cost of decreasing market friction is that it makes these high return, low risk, low capacity strategies feasible and directs investing resources and talent away from more constructive pursuits.
Hmmm, yes, I agree, this is a pretty abstract (if enormously profitable) game that many of our best and brightest are involved in. It does seem bizarre that we tolerate a market infrastructure that allows HFT players to extract such high profits so reliably, while paying rather little back and while tying up so many clever people on something essentially useless. If HFT profits were taxed at, say, 75%, then I would feel a lot better about it. But they aren’t, and probably it is politically much easier to change markets so that HFT profits are lower than to impose sufficient taxes and/or capital requirements to bring them into line. (There’s a idea: a capital requirement proportional not to your risk position but to the number of trades you do… I like it…)
In any event, though, it is clearly worth asking the question ‘what are the costs and benefits of HFT?’. It’s complicated, with a significant amount of evidence on both sides, but consideration of the sheer profitability of HFT must weigh large in any answer.