In the last edition of Markit Magazine, two representatives for the high frequency trading business share their thoughts on this controversial issue. Jose Marques, managing director and head of equity electronic trading at Deutsche Bank together with Punit Mittal, global head of electronic trading, Daiwa Securities Capital Markets discuss the pros and cons of HFT.
“ High-frequency trading is predominantly focused on highly liquid names though there is an evolution towards applying the same statistical techniques to the lower liquidity end of the market and securities with less turnover and more inherent trading risk, as these stocks are harder to exit.”
“High-frequency trading is like a chicken and egg scenario. Does it provide liquidity to markets or do traders only enter markets that are liquid enough for them to make money?” Mr. Mittal at Daiwa asks. High-frequency trading can offer increased market liquidity and greater efficiency. The two heads of electronic trading offer their insights on its role in market-making.
Jose Marques (Deutsche Bank): High-frequency technologies promote market efficiency by providing an exchange-like service, which tightens spreads, increases liquidity and allows profit-taking.
Strategies that focus on the passive side of a trade are an important liquidity provision for the market.
These tend to be statistical trades with relatively short horizons and the goal is to make money through spread capture and market rebates received in the
course of posting orders.
With market latency arbitrage, high-frequency trading technologies work to keep prices in line when there are different quotes on different venues.
Other strategies, with mean holding periods of a few seconds or minutes, help remove inefficiencies from the market, such as a relative mispricing between securities.
This could be an exchange-traded fund (ETF) versus a basket of stocks or between stocks that have a high degree of correlation with each other. Speed matters, independent of the holding period horizon and trading objectives.
Take for example, an index or ETF arbitrage strategy, where traders are making markets based on observed prices in the underlying securities.
The Need For Speed
When there is a significant enough price movement, traders want to react quickly and update their quote.
The need for speed is not based on how quickly you accumulate your position because you are on the passive side of the trade. It has more to do with when new information comes into the market and how quickly you can take down your old quote and replace it with a new quote that reflects that new information.
In order-driven markets, bids and offers never arrive simultaneously, so
there is always a need for a liquidity provider, i.e. the economic agent that
bridges the mismatch in time between buy demand and sell demand.
Historically, human market-makers have filled the role of providing a continuous quote to help facilitate trading.
However, as technology and regulatory innovation, such as Regulation National Market System, has allowed markets and trading to become faster, so the human market-makers’ ability to quote effectively has become harder to accomplish.
Machines and algorithmic processes have largely supplanted the human-driven liquidity providers and high-frequency technologies are now filling the role as the specialists and market-makers of old.
The result is probably a substantial net increase in efficiency of US equity markets, in terms of spreads coming in and frictional costs falling.
“High-frequency trading is predominantly focused on highly liquid names though there is an evolution towards applying the same statistical techniques to the lower liquidity end of the market and securities with less turnover and more inherent trading risk, as these stocks are harder to exit.”
Though there has not been an explosion in volume in these smaller stocks, that same level of automation we see in the high liquidity sector is being introduced.
However, the amount of high-frequency trading is limited by the amount of long-term turnover.
The role of the high-frequency trader is to accumulate that liquidity and
deliver it to the buyside by matching trades over small horizons.
If that buyside trader is not there, then the high-frequency trader cannot provide the service.
In the race to capture the modern market-maker – the high-frequency trader – and be the fastest venue, exchanges have possibly overlooked their key regulatory responsibility and obligation to provide orderly markets.
Exchanges have been reticent to put in place risk and limit checks and circuit
breakers to halt or slow trading that would have prevented the great and
sudden price dislocations seen on May 6th 2010, a largely avoidable event.
“Part of what exacerbated the situation on May 6th was high-frequency traders not being able to easily understand what was going on and so they stopped providing liquidity. This led to price movements being greatly exaggerated and so over the horizons they transact, high-frequency traders actually create genuine liquidity and damp volatility.”
A Chicken And Egg Scenario
Punit Mittal (Daiwa Securities Capital Markets Co Ltd): High frequency trading is like a chicken and egg scenario.
Does it provide liquidity to markets or do traders only enter markets that are liquid enough for them to make money?
I believe it is a bit of both, though many strategies depend on very liquid markets in both cash and derivatives.
As there are more execution venues in the US to trade, we have seen liquidity grow in US equities, which has also provided more arbitrage opportunities
for high-frequency players.
We have seen the same impact in Europe after the introduction of Markets in Financial Instruments Directive with more venues emerging, such as Chi-X and Turquoise, and high frequency trading playing a big role in generating liquidity and market-making on these platforms.
Read the full post at The Swapper:
Related by the Econotwist:
- A new paper on high-frequency trading (marginalrevolution.com)
- Convenient Timing: FINRA’s Quote-Stuffing Fine Comes Two Weeks Before Big Schapiro Announcement (businessinsider.com)
- First high-frequency trading firm fined for manipulation (financialpost.com)
- The High-Frequency Trading Challenge: Explain It (blogs.forbes.com)
- Vanguard’s Gus Sauter Thanks High-Frequency Traders (blogs.forbes.com)
- High-frequency traders: Spread betting (economist.com)
- UPDATE 2-SEC commissioner questions new market maker rules (reuters.com)