High-frequency trading (HFT) has attracted considerable negative
press coverage recently. Is any of it
warranted? In a recent paper,1 I review the existing academic research on HFT so that researchers,
practitioners, policymakers, and other interested parties can become familiar
with the current state of knowledge and some of the outstanding economic
issues. Rather than relying on emotional
appeals, regulators need to consider the evidence on HFT and automated markets.
HFT firms can trade thousands of times per day for their own
account, with typical holding periods measured in seconds or minutes. Many HFT strategies are not new. They are familiar trading strategies updated
for an automated environment. For
example, many HFTs stand ready to buy or sell like traditional human market-makers,
but with lower costs due to automation. As
a result, HFT market-makers have mostly replaced the human variety. Other HFT strategies conduct cross-market
arbitrage, such as ensuring that prices of the same share trading in both New
York and London are the same. This trading
strategy can be implemented faster and at lower cost with computers.
Liquidity – the ability to trade a substantial amount at
close to current market prices – is an important, desirable feature of
financial markets. The key question is
whether HFT improves liquidity and reduces transaction costs, and economic
theory identifies several ways that HFT could affect liquidity. The main positive is that HFT can
intermediate trades at lower cost due to automation. These can be passed on to investors in the
form of narrower bid-ask spreads and smaller commissions. The biggest potential
negative is that the speed of HFT could disadvantage other market
participants. The resulting adverse
selection could reduce market quality.
There is also the potential for an unproductive arms race among HFT
firms racing to be fastest.
Over the past ten years, HFT has increased sharply, and
liquidity has improved markedly. But
correlation is not necessarily causation.
Empirically, the challenge is to measure the incremental effect of HFT
on top of other changes in equity markets.
The best papers for this purpose identify market structure changes that either
facilitate or discourage HFT. There have
been several such changes, and the results in these papers are consistent. When a market structure change leads to more
HFT, liquidity and overall market quality have improved. It appears that market quality improves
because automated market-makers and other liquidity suppliers are better able
to adjust their quotes in response to new information.
A remaining concern is that HFT could make
markets more fragile, increasing the possibility of extreme market moves and
episodes of extreme illiquidity. During
the May 6, 2010 Flash Crash, for example, S&P futures fell almost 10% in 15
minutes before rebounding. Some individual
stocks moved far more. During the Flash
Crash, the CFTC and SEC find that HFT firms initially stabilized prices but
were eventually overwhelmed, and in liquidating their positions, HFT
exacerbated the downturn. This appears
to be a common response by intermediaries, as it also occurred in less
automated times during the stock market crash of October 1987 and a similar
flash crash in 1962. Thus, there does
not seem to be anything unusually destabilizing about HFT, even in extreme
market conditions. Short-term individual
stock price limits and trading halts have been introduced since. This appears to be a well-crafted regulatory
measure that should prevent a recurrence.
A trading pause should give market participants a chance to re-evaluate
and stabilize prices if the price moves appear unwarranted. More recently, stocks fell by about 1% in
less than one minute after false rumors about explosions in Washington circulated
on a hacked Associated Press Twitter feed.
Trading pauses could also be useful in cases like this.
Regulators in the US and abroad are considering other
initiatives related to HFT. Many issues
associated with HFT are the same issues that arose in more manual markets. For example, there is concern about the
effects of a two-tiered market. Today,
the concern is that trading speed sorts market participants into different
tiers. In the floor-based era, the
concern was access to the trading floor.
Many of the abuses in the floor-based era were due to a lack of
competition. Now, regulators are
appropriately relying on competition to minimize abuses. If there is some sort of market failure,
however, then robust competition may not always be the solution, and regulation
may be in order. In evaluating any
regulatory initiative, it is important to identify the market failure and to ensure
the cure isn’t worse than the disease. Proposed
regulatory initiatives include:
audit trails. Audit trails have always been needed for
market surveillance, and robust enforcement is important to ensure investor
confidence in markets. With HFT,
malfeasance is possible in order submission strategies, and it may be possible
to hide by scattering trades across different exchanges, so regulators need
ready access to order-level data from each trading venue.
Order cancellation or
excess message fees. If bandwidth and data processing requirements
are overwhelming some trading venue customers, it may be appropriate for
trading venues or regulators to set prices accordingly and charge the
participants who are imposing those costs on others. Some markets around the world have imposed these
fees. There could be unmeasured benefits,
but the early evidence suggests that market quality worsens, as liquidity
providers widen their spreads and reduce depths to avoid the fees or recover their
Minimum order exposure
times. Under these proposals, submitted orders could
not be cancelled for at least some period of time, perhaps 50
milliseconds. This would force large
changes in equity markets and could severely discourage liquidity provision. The economic rationale here is particularly
suspect, as the overriding goal in market design should be to encourage
liquidity provision. But this hasn’t really been tried yet, so there is no
empirical evidence one way or the other.
taxes. Based on jurisdictions where transaction
taxes have been imposed, removed, or changed, it is clear that these taxes
reduce share prices, increase volatility, reduce price efficiency, worsen
liquidity, increase trading costs, and cause trading to move offshore.
Restrictions on order types
. Exchanges and trading venues have introduced
a variety of new order types in the past few years. HFT firms are the main adopters, and there is
concern that these could disadvantage other traders in some way. Studying the empirical effects would be
vast majority of the empirical work indicates that HFT and automated, competing
markets improve market liquidity, reduce trading costs, and make stock prices
more efficient. Better liquidity lowers
the cost of equity capital for firms, which is an important positive for the
real economy. Minor regulatory tweaks
may be in order, but those formulating policy should be especially careful not
to reverse the liquidity improvements of the last twenty years.
Charles M. Jones (2013), “What do we know about high-frequency trading?”,
working paper, available at ssrn.com.
The paper is based on a number of previous lectures and talks on HFT
with the same title; Citadel (an HFT firm) provided financial support to turn
the slides into a paper.