How High Frequency Trading Benefits All Investors
tradersmagazine.com
tradersmagazine.com
So I've not read the linked article, nor am I going to. But I will say this: HFT does perform a viable, necessary economic function. A well-functioning capital market absolutely requires this kind of activity.
HOWEVER, like most mainstream-media memes, what gets talked about / opined on is almost never relevant to what is actually important and/or controversial: in this case, the question of whether HFT creates a two-tiered playing field where individual (read: non-technically-sophisticated) investors suffer at the hands of the "pros".
Most arguments against HFT basically say that algorithms are purely predatory and only serve to hurt the performance of large investors. This is naive at best and deceptive at worst; for every share I purchase "ahead of" a big order, a seller has been filled at the price he desired. Every transaction has two sides; you can't just pick one and say they got screwed. The other side has to have done as well as the other did poorly (assuming a fictional frictionless world).
The reality is that HFT requires tons of knowledge and a technology budget of seven figures per annum at the barest minimum, and this provides a very real barrier to entry. What should be talked about, but never is: is that ok? Why or why not? What ramifications does it have?
I don't need to justify my activity, nor do I want to go that route--my point is that the fact that participants can realistically expect a fill is not something that happens because of magic.
You make the same assumption yourself, every time you trade. The entire purpose of high frequency trading is to beat others to good deals -- not to do a better job of discovering good deals.
(so speed is important to you, just as water is important to a fish; it may not be what you focus on, but that doesn't mean that it's not critical).
There are market participants who make their money on pure latency arbitrage; it is a 100% speed game (because anyone can figure out that 1 - 1 = 0).
The majority of HFT falls into the "you have to be fast enough to not get run over" bucket.
I'm fairly sure this is the answer: They don't -- instead, they're just good at noticing, very quickly, the actions of the market actors who do. Which is just another way of saying that they're about beating others to the deal.
(I'd also guess that they're probably also quite good at handing recreational day-trader's asses to them.)
If you look at markets through an information-centric lens, it seems possible to draw a clear distinction between actions that introduce external data and those that are pure acts of deduction, no matter how brilliant.
The question is, why can't the buy and sell orders be matched directly, allowing the buyer to pocket the discount off the price he was willing to pay, instead of the difference going to an HFT with access to the incoming order stream? What possible benefit is provided to the market by skimming off the difference like this?
The behavior I talked about above is one of the objections to HFT as it's currently practiced, and I'd like to know whether it reflects a misunderstanding.
In terms of you justifying HFT activity, of course not. There have always been advantaged participants and HFT traders are simply those today. But the article was trying to justify HFT as manna for all participants, which seems unlikely considering how much money the industry is extracting for their liquidity-providing services.
Does the fact that Kinkos invests millions in fancy printers make the photocopying business unfair?
And I do completely understand the argument for liquidity: more transactions = more accurate price discovery. But I think problem here is that this entire field is black box, meaning property trading algorithms and trading patterns can and are used within the system. This can allow a trading AI to go out into the market place, look for pattens, and to create and cancel millions of orders within the fraction of a second.
I'm sure you know about the former Goldman Sachs programmer who was charged with theft by the FBI. It was totaled at around 32 megabytes of software code. Not very much. But Goldman insisted that if this code got out into the market it would be detrimental to their business and violate their trades secrets confidentiality clause. Not to mention Goldman's largest profit center in their business is their proprietary trading desk, which is heavily into HFT.
My contention is that if we are really interested in a utility that uniformly benefits the market, then let's have an open source platform that provides that, so we can verify that any of these firms aren't "front-running" their trades.
Thats my opinion. I think a lot of the debate over HFT is just filler, it doesn't matter. The guys who are hip to the scene are already making a killing on it now, and it may last a few more years before we begin to regulate.
Colocation agreements usually require a minimum commitment of 12-36 months... probably $10k/mo if you have some rudimentary failover and the like.
I'd say anyone who tries with less than 12 months and $500k to truly burn has 0 shot at success. And if you want to really do it right, you're looking at an order of magnitude more.
But they would have been filled at the price they desired if they sold directly to the big order, as well. The end effect of the hft systems is just to run up the big order to the max of what they're willing to pay, and take their profit as the difference between that max and the original offer (split up between however many of these things managed to make it over to the feeding frenzy before the real buyer got what they wanted).
I do think it's legitimate to look at sources for articles, especially when there are strong conflicts of interest.
Romans 13:1
That being said (disclaimer: I am a HFTer), this article is a pretty weak defense of HFT. Like others have pointed out it makes a lot of assertions not based on data/fact. However, I've yet to read a criticism of HFT that doesn't commit the same mistake (and I've read a lot of them).
For a defense of HFT that uses hard data I'd direct people here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1501135
Is it clever arbitrage? is it a massive denial of service so some people can play middle man? I don't know.
However, Cameron Smith has created an excellent straw man of his opponents. This is an ad hominem argument.
The article contains a number of assertions, central to its claim but with little evidential support in the article. (For instance: "No serious market observer disputes the claim that volatility would not be higher without the liquidity provided by high frequency traders" -- has the author really looked hard for serious market observers with a different opinion? -- and "High frequency traders can only trade profitably when their trades push a stock price towards fair value"; what exactly is "fair value" supposed to mean, why shouldn't there be short-term bubbles among HF traders just as there are long-term bubbles among slower traders, and who says HF traders can't all happen to trade unprofitably in some particular case?.) It may very well be that those claims are true, but we basically have to trust the author. And that is what we may quite rightly and rationally be less inclined to do, if we know that the author has a vested interest in persuading us.
The 'fair value' he's talking about us just the supply-meets-demand of that stock for that particular moment-- that moment could definitely take place in a larger bubble of that security. The mini-bubble within high freq trading he refutes by reasoning only ("another hft would detect this"), so I think a more concrete example would've been more convincing. As with all bubbles the question is how far out of line can the price get, and how quickly will the price be brought back to reality
The author seems to be trying to say that high frequency traders reduce volatility. But I parse the claim differently: it seems to me to be saying that volatility could only be lower in the absence of liquidity from high frequency traders.
As to the rest of the argument, it seems to be structured along these lines:
* More efficient markets with lower spreads between buy and sell are good. I think this is a valid claim, but I don't think it follows from the existence of high frequency trading, but rather from more efficient, automated trading systems.
* High frequency trading helps supply market liquidity, and this liquidity is good. I can buy the first part of this, and the second part seems mostly true.
* Old-fashioned purchasers seem to be annoyed that when they make a large purchase, the price for the last share is higher than the price for the first share, because the market has already reacted to the change in supply and demand. He also makes the argument that were this not so, the sellers of shares would in effect be subsidizing purchasers. His case seems solid enough to me.
* But he then makes another claim that seems to contradict it. He suggests that companies with stocks that have low volume turnover are unduly affected by small purchases, and since high frequency trading increases volume, the impact is reduced.
* Finally, it seems he would like to claim that because "our nation's equity markets are far fairer, more efficient, more liquid and have lower transaction costs for investors than ever before", high frequency trading should claim a substantial portion of the credit.
"No serious market observer disputes the claim that volatility would not be higher without the liquidity provided by high frequency traders."
"[serious market observers believe] that volatility would not be higher without the liquidity provided by high frequency traders."
"[serious market observers believe] that volatility would [be lower] without the liquidity provided by high frequency traders."
"[serious market observers believe] that volatility would [be lower] without ... high frequency traders."
"[serious market observers believe] that volatility [is higher with] ... high frequency traders."
"[high frequency traders increase volatility]"
This, of course, is exactly the opposite of what the author proceeds to argue in the following paragraphs. My conclusion is that the author managed to create a sentence so overly complicated that even he could not understand what he was saying.
2) HFTs provide transparent price discovery. This means that the computer programs the HFTs have set up will quickly and unambiguously tell you at what price they are willing to buy and sell shares. Contrast this with a hypothetical process in which you had to haggle with human representatives of each shareholder or potential buyer in order to figure out the price. It's similar to consumer vs. enterprise software sales (sticker price vs. "well, how much can you afford?"). In theory, transparent price discovery promotes fairness (everyone sees the same price) and encourages trading due to decreased latency and hassle.
3) Lots of repetition of 1 and 2. Also an assertion that HFT decreases volatility (average dPrice/dt), while most commentary on the matter assumes that it would increase volatility, due to algorithms that are either busted ( e.g., http://arstechnica.com/business/news/2010/01/how-a-stray-mou...) or interacting with one another in a bad way. It is disconcerting to me that the author cites empirical evidence without a hint of intuition or insight to help the reader generalize it; however, it is difficult to dismiss the evidence off-hand without looking at it more closely and/or being more expert than I in the matter.
Points 1 and 2 are by far the most common and obvious arguments for HFT, and the analysis in TFA is not bad, but not exemplary either. The rest of the article is basically redundant and comes off a little defensive. I found this article interesting ( http://www.zerohedge.com/article/whoa-glitch-hft ), though its tone is also less-than-objective.
I don't see why there's any particular reason that's true. High-frequency traders can trade profitably whenever their trades are in line with (very) short-term price movements. Ideally everything works together to push prices towards fair value, but you can't assume that as an axiom, since that's the main point being disputed in that section (the one on volatility).