What if High Frequency Trading Is Really a Good Thing?

by: Babak

High Frequency Trading is not only the fastest growing subset of trading, it is equally lucrative and controversial. The public perception of HFT is incredibly negative with most people believing that it has a negative effect on price discovery, liquidity and that plainly put, it isn’t fair.

That public perception may need to be adjusted according to this recent research by finance PhD candidate, Jonathan Brogaard (Kellogg). The paper looks at the effect of HFT on equity markets and through analysing the strategies used by these firms it considers their profitability, impact on market liquidity and volatility.

There is no evidence that HFT contribute to price discovery, liquidity and actually reduce volatility. There is also no evidence that they engage in front-running. HFT demand for liquidity (50.4%) is slightly lower than their supply of liquidity (51.4%) and they provide the inside quote about 45% of the time.

If HFT’s were not market participants, the average lot trade (100 shares) would have an adverse price movement of $0.013 more than it does currently (for trades of 1000 shares, the adverse price movement would be $0.056). Usually they engage in counter-trend strategies, especially when demanding liquidity.

I don’t think this settles the question once and for all. But we need this sort of rational discussion and research much more than anecdotal evidence and emotional outbursts. Whether you like it or not, High Frequency Trading is here to stay because it provides lucrative returns for everyone involved. The 26 HFT firms in the study earned $3 billion annually. The exchanges that receive collocation fees are also benefiting. And let’s not forget that for all the controversy, there is nothing illegal about HFT.

So the real question is, given the reality that the market structure has changed, how are you going to adapt? The SEC is currently engaged in a thorough study of the May 6th flash crash and will be releasing the results later this month. While “quote stuffing” got a lot of attention recently as a potential cause, based on preliminary statements from chairperson Schapiro, it doesn’t look like the SEC is following that lead.

The only significant change to market structure was the end of stub quotes on both Nasdaq and the NYSE. These are minimum and maximum quotes provided by market-makers in order to technically qualify as providing a market in a stock. This change was made to prevent the new individual circuit breakers from being triggered.

Here is the full study referenced above:

Source: Jonathan Brogaard