In the Catholic Church, the Promoter of the Faith in the
process of canonization (or sainthood) argues against the candidate being
considered for the honor. Given recent media attention in HFT, these quants need their own promotor fidei. Consider first, high-frequency
trading is a small (in number of firms and capital) subsection of electronic
trading. Although recent media attention towards electronic and algorithmic
trading has focused on the negatives these advances in
global markets have produced more efficient outcomes as well.
Larry Harris of USC Marshall Business School has provided an
excellent introduction to the digitization of markets and trading. His account
is balanced between trends, benefits and parasitic HFT strategies. As I have
already discussed the pitfalls of high-frequency trading and the Flash Crash,
this post will focus on the benefits of high-speed trading. He attributes the
success of electronic exchanges and trading to efficiency. Harris cites a
number of benefits, including:
- · Faster executions
- · Decreasing trade sizes
- · Falling bid-ask spreads
- · Increased volume
- · Decreasing large trade costs (for 1M shares on $30 stock)
- · Increased liquidity in the markets
Faster executions, decreasing trade sizes, falling bid-ask
and increasing volume: The implication with this and several others on the list
is that electronic trading increases liquidity in markets. Not only can buyers
and sellers complete trades faster, smaller orders can be processed than
before. Where in 2004 trades took 15-25 ms, in 2011 they took <3 ms.
Similarly, trade sizes on the NYSE decreased from 800 shares
to 300 between 2004 and 2011. The former is an improvement in efficiency, and superficially,
the latter is an improvement in liquidity, however, liquidity is not
necessarily defined by order sizes. Low trade sizes and high volume are
typically used to test liquidity of an asset, but liquidity is really the ease
of buying an asset in the market. HFT front-running actually decreases
liquidity although it increases volume and encourages lower trade sizes
(remember the feeler orders sent out by HFTs from an earlier post?).
Bid-Ask spreads have lowered from 7 cents in 2001 to under 2
in 2013. This term refers to the difference between the lowest price a seller
is willing to sell a security and the highest price that a buyer is willing to
pay for that same security. Lowering the bid-ask means the seller and buyer are
closer to making a deal. Often, firms offering investment products will look at
median bid-ask spreads to see how the product is trading and guide their
product promotions.
One problem remains, most of Harris’ argument focuses on
electronic trading, but what of HFT in particular?
During the course of Peter Nabicht’s public beating on CNBC,
he made several interesting points about high-frequency trading. For one, HFTs
are not designed to game the market, they are more efficient processors of information
and trade executions. The way they are used has brought up issues of scalping
and “rigged markets,” as Brad Katsuyama asserts. Mr. Nabicht is absolutely
correct in saying it’s the misuse of technology. Front-running does not simply
happen when an HFT is waiting at your closest stock exchange for your order so
that it can beat you to the other exchanges.
Enter the Dark Pool: (for more on this topic, read Scott Patterson's WSJ articles and book called Dark Pools ) Institutions have dark pools ostensibly
because it allows large investors to buy or sell big without others noticing
and compounding the upward or downward effect on the stock. As detailed in Flash Boys, Rich Gates of TFS
Capital, noticed that the rates of internalization (or percentage of customers’
orders filled within the dark pool of a bank) were exceptionally high given
their small share of the overall market. Mr. Gates sent two orders, one was a
buy order sent to a dark pool at $100.05 for Chipotle and the other was a sell
order sent to a public stock exchange at $100.01 for Chipotle. Due to
Regulation NMS and the NBBO stipulation, he should have been able to sell
himself the Chipotle shares for $100.01 because it was the best offer
available. However, almost immediately, he had sold his shares for $100.01 and
bought shares for $100.05. HFTs, he learned after repeated tests, were able to
front-run within the dark pools. They could see the big trades being made and
front-run them to the public exchanges. Once again, like in Mr. Nabicht’s
defense of HFT, we see that it is the misuse of technology which makes HFT the
villain.
Maybe you are a buy and hold investor who has values his
investments with a margin of safety well above 4 cents, and Benjamin Graham
would certainly give you a “check plus,” but for the sake of fair markets, how
can we reign in the overwhelming speed of the HFT, and should we?
Next time: This blog bids its readership a fond farewell with a discussion of the Flash Crash, Reg NMS, and of course, our own “animal spirits.”
Title courtesy of Samuel Taylor Coleridge (1772-1834)
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