High-frequency technology has been blamed for sudden instability in the markets, most recently when the Bats equity exchange canceled its initial public offering after a computer glitch caused chaotic trading in its own stock and others.
But criticisms of HFT are overblown, and regulating potential abuses isn’t as hard as many believe. In fact, more regulation unless wisely applied is likely to do more harm than good.
Critics are concerned that traders with low-latency technology, who often pay to locate their servers near an exchange’s systems to decrease messaging delays, have the earliest access to market data.
But info timing asymmetries have always existed. Specialists and floor traders have always had price information ahead of the rest of the market. In the mid-1990s, the “SOES bandits” took advantage of human market makers by using Nasdaq (NDAQ)’s Small Order Execution System to place orders before humans could update their bids and offers.
Speed of information and execution is everyone’s objective in the marketplace — and the current trading infrastructure is no more than a logical extension of a long-term trend.
Benefits of HFT
In a study published March 19, Ana Avramovic of Credit Suisse Group AG showed that intraday volatility has actually been steadily decreasing since 2005, even as HFT has increased. In 2008, of course, daily volatility shot to the highest level since 1932, as traders responded to the collapse of Lehman Brothers Holdings Inc. But 2011 ranked only 16th in terms of daily volatility in that period, and was less volatile than 2000 and 2002, years when HFT was less prevalent. Find out about the strategies and algorithms.
Avramovic also found tighter spreads and greater liquidity for the national best bid and offer since 2004. She concluded that, as far as HFTs were concerned, “at a minimum, markets are not worse for their presence.” This has been corroborated by a number of academic and industry sources.
The reason why is that automated market makers (or AMMs), a subset of HFTs, are liquidity providers. Their quote-and-cancel rates may be high, but unless they offer the best price in the market, they won’t get order flow.
Some argue that AMMs are less reliable than traditional market makers and that their liquidity evaporates in a crisis as in the May 6, 2010 “flash crash.” Some AMMs did indeed abandon the market that day, and left the infamous, and now banned, stub quotes (buy at $0.01, sell at $10,000) as evidence. But AMM systems automatically stop trading when market data appear out of normal bounds or when regulatory capital reaches prescribed limits. These are reasonable actions. Had AMMs kept trading, they would have been criticized for not having appropriate risk systems in place.
More to the point, after a few minutes of analysis, managers responded to the flash crash by quickly restarting their systems and driving the market to a recovery within half an hour — as opposed to the year it took to recover from the stock-market crash of 1987. A report on the flash crash by the Securities and Exchange Commission and the Commodity Futures Trading Commission notably did not place the blame with high- frequency traders. Those who question the reliability of AMM liquidity forget that liquidity itself has always been a fleeting and fitful commodity in our markets.
Do esoteric quant models, which also require little human interaction, pose a threat? It depends on the model. Models based on momentum strategies may exacerbate volatility. But quants are most often based on arbitrage strategies, which I believe smooth markets and lower volatility. In examining many of the models, it is clear that they use techniques similar to the technical analysis I learned decades ago — only now exploiting access to real-time data. This is neither illegal nor unexpected. It’s merely a consequence of technological advances.
Some HFT practices do require further scrutiny. Momentum ignition (in which traders take a position and then start rumors or place orders to quickly drive the market up or down) and layering (where traders place orders in the market-order books to imply substantial buying or selling pressure without the intention of executing) could both open the door to market manipulation.
Read More: Bloomberg