The following was first published by the National Post on November 20, 2013
On Thursday, the Investment Industry Regulatory Organization of Canada (IIROC) is scheduled to release its much-awaited study on high frequency traders. The standard image of the high frequency trader (HF trader) is that of a slavering troll working assiduously to destabilize world stock markets and laughing gleefully while prying gold fillings out of retail traders’ mouths. In the minds of many, HF traders caused or greatly contributed to the infamous U.S. “Flash Crash” of May 2010, when the Dow Jones plunged (and then recovered) 1000 points (roughly 9%) in a matter of minutes. HF traders also stand accused of increasing trading costs for both retail and institutional traders.
Academic evidence, however, suggests that HF traders sport toes, not cloven hoofs. Indeed, as noted by the European Commission, “HFT is typically not a strategy in itself but the use of very sophisticated technology to implement traditional trading strategies.” The essence of the “sophisticated technology” is speed. HF traders use highly refined computer algorithms to wade through reams and reams of data, spot profit opportunities, and execute trades to exploit these opportunities. HF traders also use “co-location” to enhance speed. This refers to the now-common practice of paying for the privilege of locating one’s servers in the same building as a trading venue’s computer matching engine (where trades actually get executed). This reduces system “latency” (the time it takes for a message to travel from the HF trader’s computer to the trading venue’s computer, and vice-versa) to a bare minimum.
Being the first in line has been a source of profit as long as there have been tradable assets
The HF trader’s speed advantage in general, and co-location in particular, have been much vilified. But superior speed is neither new nor objectionable. Savvy stock traders have long enlisted the latest information technologies to gain an advantage over their rivals. At one time, carrier pigeons and optical semaphore systems were the preferred tools.These gave way, in succession, to the telegraph, the telephone, the Internet, dedicated data lines, and now, co-location. Being the first in line has been a source of profit as long as there have been tradable assets. That goes back not merely decades or centuries, but millennia.
While the clay-footed are never amused to see more fleet-of-foot rivals steal their business, a simple self-help strategy awaits – go out and get your own carrier pigeons. And indeed, more and more traditional players, such as sell-side institutions, are doing just that, putting their own servers in co-location facilities and competing head-to-head with HF traders.
But in any case, the corpus of academic evidence suggests that both retail and institutional traders have benefited from the presence of HF traders. Market making is a case in point. HF traders effectively “make a market” in particular stocks by posting limit orders to buy and sell on the books of various trading venues. However, they are able to quote much narrower bid/ask spreads than traditional market makers.
This is a direct result of their speed. HF traders have no interest in holding stock overnight. As soon as they purchase shares in a given company, they look to sell these shares, and often do so within milliseconds. The extremely short interval between the two legs of any round trip transaction (buy/sell or sell/buy) minimizes the extent to which the HF trader is exposed to what economists call “adverse selection risk,” which is the risk of adverse price movements between the first and the second leg of the round trip. This enables them to effectively quote very tight bid/ask spreads. The academic studies are virtually unanimous in suggesting that when HF traders arrive, bid/ask spreads shrink by a material amount. This benefits all other traders, whether retail or institutional.
HF traders have benefited from the now common practice of “maker/taker” pricing. This involves paying a rebate to the “passive” side of a transaction (the party who enters a limit buy or sell order on the books of a given trading venue) and charging a fee to the “active” side (a later-arriving order that is matched to the passive order, resulting in a completed trade). Speedy HF traders are more likely than others to be on the passive side of a transaction, and thus go home with the lion’s share of the trading rebates.
On the other hand, many non-HF traders (i.e. the ones who now disproportionately end up on the active side of the transaction) have seen their trading costs increase. Nonetheless, it is not clear if this increased trading cost is passed on to the client, as opposed to being partly or wholly absorbed by the market professional (as we would expect in a competitive market). But even if all of the cost is passed on to the trading client, reductions in bid/ask spreads more than compensate.
HF traders are associated with other improvements in market microstructure. For example, studies show that HF traders are more likely to be “informed” traders, and that their presence in a given market improves price discovery (the rapidity with which new information is impounded in the public share price). As against the charge that HF traders make financial markets more volatile, the studies show that when HF traders come calling, intraday price volatility (the degree to which stock prices fluctuate during the course of the day) actually diminishes.
And what of the Flash Crash? The Crash was triggered when a single U.S. mutual fund decided to liquidate $4.1-billion of something called the E-Mini S&P 500 (an equity futures contract based on the value of the S&P 500). Initially, HF traders absorbed some of this volume. However, when it came to executing the second leg of the round trip and selling the E-Mini to someone else, there was trouble. The volume of the mutual fund’s sale order was so large that it exerted a continual downward pressure on the price of the E-Mini. HF traders – just like traditional market makers – found that they could not buy cheap and sell dear. Many withdrew from the market, causing E-Mini liquidity to dry up. Even worse, the liquidity drought was transmitted broadly throughout the market, since the falling value of the E-Mini implied lower values of the stocks underlying the E-Mini contract – namely, the entire S&P 500. These stocks (and others) also went into a death spiral. The imbroglio was ended by a trading halt. Five minutes later, trading was restored, and the market recovered and marched stoically onward.
The Flash Crash is in indictment of HF traders only if we can conclude that they bailed from the market faster than traditional market makers. In fact, the evidence is precisely the opposite; some HF traders hung in until the bitter end. Moreover, numerous studies show that HF traders are slower than traditional players to run for the exits when the going gets rough. A market populated only by traditional market makers would not have avoided the Flash Crash.
Despite all of the favourable academic reviews, many institutional traders swear up and down that HF traders engage in a bevy of manipulative or otherwise unfair trading practices. One Canadian study by Cumming et al., however,finds that HF traders reduce the incidence of end-of-day price manipulation. A U.S. study finds that HF traders do not “front run” institutional orders, as has often been alleged. Nonetheless, the empirical record in this respect is not well developed, and there is certainly anecdotal evidence of dirty tricks being played by HF traders. Academics need to sharpen their pencils in this regard and Canadian regulators need to stay sharp and devise means of detecting these dirty deeds and punishing them accordingly.
A further caveat is that HF trading has led to an increasingly intense arms race with a view to shaving not merely milliseconds, but microseconds off system latency. At some point, the commitment of ever-larger sums of money to slicing ever-smaller fractions of time off trading times, just to be first in line, becomes socially counter-productive. In other words, the last chapter on HF trading has not yet been written.
Jeffrey G. MacIntosh is Toronto Stock Exchange Professor of Capital Markets, Faculty of Law, University of Toronto, and a director of the Canadian Securities Exchange. He is the author of the C.D. Howe Institute’s “High Frequency Traders: Angels or Devils?”
