By Alex Frino
The Capital Markets Cooperative Research Centre (CMCRC)’s Alex Frino talks about his research over the past 18 months and the conclusions as to the truth about high-frequency trading.
What inspired you to focus your research on High Frequency Trading (HFT)?
There is a very poor understanding of the impact of HFTs on the market place. There is a lot of ill-informed opinion in circulation about the impact of HFT on price volatility, and their contribution to liquidity. I wanted to provide some hard data to help markets move forward and inform sensible evidence-based policy decisions.
There was also considerable interest in the idea of conducting HFT research from our regulator partners, including the FSA and ASIC.
What were your views on HFT at the outset of your research program?
When we first set about doing the research 18 months ago, I began by speaking to the investment management community to gather their views and insights into HFT and its impact on their trading. The feedback I got was overwhelmingly negative. One comment sums it up best – an investment manager said to me that “liquidity provided by the HFT community is like fog – you can see it, but when you reach out to grab it, it is not there.” So I began the program expecting to confirm these dominant views. To my surprise we discovered that the realities about HFT are almost exactly the opposite of that the investment managers were telling me.
HFT liquidity has been described as ephemeral by many on the buy-side. What does your research suggest about the ability of the buy-side to interact with HFT liquidity?
We have done research with data from the LSE, ASX, SGX, NASDAQ and NYSE Euronext on exactly this subject. The exchanges furnished us with data that identifies when HFTs are present in the market place. We then looked at the make-take decision. HFTs make liquidity when they put up a quote that gets hit by someone on the other side of the trade. They take liquidity when they hit someone else’s quote. The data clearly showed that HFTs are net makers of liquidity.
Interestingly some of our data also included information about when firms are trading through co-located servers within the exchanges. This data too showed that co-lo HFT activity was also a net provider of liquidity in those markets.
Co-location is described by some as an ‘unfair advantage’. What is your take on that given your research into the area?
My view is that if the advantage is being put to good use in providing liquidity, then it is not being misused. That pool of co-located flow is providing liquidity that would not be there otherwise, so I cannot see how that is a negative for markets.
Many market participants – including recent widely-quoted comments by Andrew Haldane of the Bank of England – are critical of the speed and sophistication of markets generally, using HFT as their example. They argue the playing field is not level and that markets should be slowed to take away perceived unfair advantages. What is your view?
I was frankly amazed by Haldane’s suggestion that markets should be slowed [by introducing speed limits and resting periods]. What he is in effect suggesting is that we should take markets backwards by a decade. That is astonishing to me because I just do not see the arguments. Market participants who do not have the technology to compete with other players can easily access brokers with algorithmic trading engines to help them execute their trades. If you cannot or do not want to build the technology yourself, you can outsource it fairly cheaply and very efficiently.
From an HFT perspective, our research demonstrates emphatically that the liquidity they provide is real and other participants interact with it constantly, so I cannot see a problem there either.
Earlier this year, we saw some weeks of incredible volatility in global markets. Do you have any insights into how HFTs behave during times like these?
We have produced very good evidence that, contrary to popular views, there is a negative correlation between HFT activity and price volatility, meaning they actually act to smooth it out.
On face value that may seem counterintuitive but it is actually very straightforward. There are three broad classes of HFT trading:
- there are market makers, who provide liquidity and are passive;
- there are arbitragers who usually have one leg that is aggressive and one that is passive, but overall are neutral;
- then you have position takers, and within the position taking pool of order flow you have trend followers, who could ostensibly exacerbate volatility. Yet, in that same pool you also have the mean-reverters who act against those who exacerbate volatility by trading against price movements.
So when you look at the data, the HFT pool overall is overwhelmingly made up of those who either do not impact volatility, and/or actively act against volatility. So it is not surprising that we find HFT to have a smoothing effect on overall volatility.
I would be very interested indeed to do further research into the different classes of HFT trading to see which styles impact markets in what ways. We do not have that detail in our data at the moment but it is something I would like to work on.
HFTs ignore company fundamentals in their trading decisions, and many have criticized them for this. What is your view on the HFT decision-making process and its impact on markets?
HFTs do not impound fundamental information into prices, which is not their advantage and therefore economic role. We have demonstrated convincingly that fundamental information is impounded into prices by the investment management community. What the HFT community is good at is extracting information from order flow and impounding that into prices. For instance, when an HFT identifies an imbalance in supply and demand, it will enter the market and provide liquidity because that is when the market will pay for it. That is particularly true of market maker HFTs.
Regulators globally are struggling to understand how the advent of HFT impacts their markets and what they should do about it. In your experience, how should regulators approach the issue?
The first thing they must do is inform themselves. What we need is very deep and enquiring research that fully examines the role of HFTs in all market states. Before we make any rushed regulatory decisions we should await the outcome of this research. Too many times we have heard regulators around the world accept market folklore as fact. The limited research that is been produced to this point has already debunked a lot of the myths around HFT and there is certainly more to be done.
HFTs are by nature a very secretive community – have they brought their reputational issues on themselves?
Definitely. By its very nature an HFT organisation needs to protect its intellectual property and therefore they are not open to communicating widely about what it is that they do. However they have carried this attitude of secrecy across to their business communications as a whole, and for this reason they have failed to communicate the positive economic role they play in the financial community. For that reason the battles are one-sided and they are paying the price with the regulatory focus and general market negativity they are receiving. I think the HFT community really needs to come out from the bunkers and be more open about what they do.