Jul 11, 2011
HFT – Dispelling the myths
Contrary to popular belief, evidence from markets globally proves that high-frequency trading (HFT) adds value to securities markets, according to Alex Frino, CEO the Capital Markets Cooperative Research Centre (CMCRC), an Australian-based research body.
HFT is often viewed with suspicion, with some market participants characterising it as a ‘predatory’ form of trading, short-term in focus, fickle and unreliable in times of market stress, and potentially harmful to the interests of long-term investors, whose trading flow it feeds off. Only last week, Richard Saunders, CEO of UK buy-side industry body the Investment Management Association, asserted that HFT “has no economic value” and simply extracts money from the market. And on 8 July, Andrew Haldane, executive director for financial stability at the Bank of England, called for the rules of trading to be changed to take account of high-frequency trading. “The emergence of HFT in fragmented trading platforms makes for a financial market place exhibiting complexity and contagion,” Haldane told the International Economic Association World Congress in Beijing, before proposing new market-making obligations, cross-market circuit breakers and minimum resting periods as possible solutions.
Frino is convinced that fears over HFT are misplaced. In fact, he says, HFT firms already provide a valuable service to global securities markets by supplying liquidity during periods of market stress and helping to dampen extreme price movements, thus contributing to market stability.
He bases his conclusions on CMCRC’s analysis of data from major exchanges including the Australian Securities Exchange, the London Stock Exchange, Nasdaq OMX and NYSE Euronext. The centre, which is part-funded by the Australian government and supported by industry partners including exchanges and regulators around the world, has also recently explored the susceptibility of markets to insider trading and market abuse.
“I came at this from a negative angle. When I began the research, I expected the results to show that HFT was bad for the market,” says Frino. “However, the evidence revealed the opposite was true – the arguments commonly raised against HFT just don’t stand up to scrutiny.”
For example, Frino found that high-frequency trading firms actually ‘make’ more liquidity than they ‘take’ on major exchanges, pointing out that the ratio of liquidity takers to makers was consistently less than one when HFT flow was aggregated across a three-year analysis period.
HFT flow is sometimes pictured as a kind of elusive ‘fog’, explains Frino, since HFT firms are perceived as appearing to provide liquidity, only to back away from the market in times of stress. Yet the results of the CMCRC research did not back up such a view.
For instance, HFT firms typically exhibit increased participation on the London Stock Exchange during the US market opening, usually a volatile period, trading actively to reduce the price inefficiencies created by the successive peaks and troughs in value.
“Volatility goes down when HFTs enter the market,” says Frino. “HFT firms flatten out volatility and help markets find price equilibrium, since they are adept at recognising when a price movement is temporary.”
The fact that HFT firms tend to base their decisions on non-fundamental information allows them to act as a corrective against over-zealous reactions to fundamental information by long-term investors, he added.
Nevertheless, HFT is under pressure from regulators around the world. The European consultation document on MiFID II released in December 2010, for instance, suggested several measures to deal with the perceived threat to market stability posed by HFT, including an obligation for HFT firms to provide liquidity in times of market stress; a requirement for all HFT firms above a minimum size to be registered; an obligation to inform authorities of algorithms used with details on how they function; and the introduction of either proportional limits on order cancels or minimum ‘resting times’ that orders would have to spend on order books. Regulators in Canada are also currently considering whether to charge market participants for message traffic – a move that could make trading much more expensive for HFT firms, who typically send out high-volumes of messages.
Given the regulatory impetus to clamp down on HFT, Frino suggests that the need for accurate, evidence-based information is urgent. “Regulatory decisions in Europe are often made on the basis of poor information and myths,” he says. “Yet there is no evidence against HFT. That’s why it’s important to provide good information to the regulators, so that they can look at the hard evidence and base their decisions accordingly.”