A comment on HFT in the Economist

During my usual back-to-front reading of this week’s Economist I happened upon this article in Free Exchange.  This week’s study was a critique of high-frequency trading (HFT), with the allegation that HFT reduces liquidity; a solution from the study authors is discrete pricing intervals during market hours.

In lieu of making a comment on Economist website – somehow I was kicked out when I tried to post – I’ll put my thoughts below.

  • The article cites “Flash Boys” and the study for the HFT strategy front-running.  The description in the article defines the term wrong:
    • First, front-running requires customer orders; HFT have none.
    • Second, the strategy being described is much more like latency arbitrage.  Just as Rothschild’s messengers gave an information advantage during the Battle of Waterloo, or pit traders used buddies at other exchanges (via phone) to communicate market events, today’s HFT are able to use price changes at one exchange to trigger orders at another.  Nothing nefarious; just the same as before but at higher speed.
  • The ‘investor’ in the article seems to be the same as the ideal modelled by other papers: that is, some organisation/person which requires liquidity in large size, but has invested for reasons other than short-term price movements (e.g. long term investors or pension funds).  The latency arbitrage described above, and depicted erroneously in the article, doesn’t hurt the investor.  Let me explain:
    • Long-term investors require more out of winning trades than a tick or two.  That’s the margin of an HFT engaged in latency arbitrage, or indeed a market maker setting the bid/ask spread.  The spread is the cost of taking liquidity from the market maker.  If the long-term investor really cares about that tick, they should probably just lower their fees by around 1 or 2bps for their investors.
    • If the investor needs a lot of liquidity immediately, they will pay for the privilege by taking out multiple bid/ask layers in the order book.  Instead of the 1 or 2 tick spread, the investor will pay perhaps 5 or 10 ticks.  Seeing as pre-HFT market makers were routinely pricing bid/ask spreads in the 12.5 – 25 tick range, the investor is still better off with the HFT market maker.
    • This may go some way to explain why Vanguard, one of the world’s largest investment providers, is OK with HFT.
  • The article and paper cites lack of market depth for a reason to curb HFT.  But with today’s technology, orders can be issued, cancelled and replaced nearly instantaneously.  That means keeping orders in the deep book (e.g. away from the National Best Bid/Offer) is inefficient (as brokers frequently require margin to be posted to cover the order) and unnecessarily risky.
    • The risk comes from the article’s depiction of ‘adverse selection’: if I have a choice between posting offers at 5 consecutive price levels, I’m going to be very mad if some investor sweeps the offer book and I get filled on all five.  I will probably lose money.  Instead, I’ll post an offer or 2, then post other offers as I see the price move.
    • So though the market seems not to have depth, a big order will still likely be executed at a near-best bid/offer, as HFTs come to make markets.  Again, better than before, where the book depth was all there was – no one could react fast enough to get a big order filled without a huge margin for the market maker.
  • Finally, I’m not convinced by so much moralising over the wasted money on lightning-fast speed.  Most authors with a beef on HFT call this a waste of money; I could say the same about any purchase I wouldn’t make.  The fact is this ‘arms race’ frequently cited is actually good for everyone but the HFTs that must continually spend the money, slowly putting themselves out of business.  It’s a bit like the recent OPEC announcement, keeping production high: the only ones really hurt by the announcement are governments which rely upon oil revenues to keep finances in check.  The rest of us get an early Christmas gift.

The paper’s authors attended a CFA conference weekly, and discussed the topic.  A summary is here.  Similar to other calls to curb HFT, the solution seems awful woolly; particularly for getting rid of a system which generally works, but would require wholesale changes to obtain the desires of opponents.

End soapbox.

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4 thoughts on “A comment on HFT in the Economist

  1. Mike says:

    But HFT does have customer orders- its called payment for order flow. “Some of the biggest retail brokerage companies are Charles Schwab Corp., TD Ameritrade Holding, Fidelity Investments’ Fidelity Brokerage Services and E*Trade Financial Corp, which can get paid $100 million a year or more for selling their orders.” So, no customers, those are considered clients right?

    Vanguard is ok with HFT, huh? Well Charles Schwab isnt- “High-frequency trading is a growing cancer that needs to be addressed.” Who is right?

    Look bro, the economist article is very weak indeed. Im not anti-HFT but Im certainly not pro-HFT either. Do you work for an HFT firm? If not, then why do you want to defend them? As a trader, I just want my whole order (or as much as possible) filled at the best price possible. That means I dont want my broker handing my order off to Citadel for them to give me whatever execution they feel like, even though that whatever price they give me will most certainly be better than what I would have gotten 10 years ago. If the schoolyard bully who used to steal all of your lunch money now only steals half of it, thats still wrong right? I want my order sent to an exchange that is public (i.e. not “dark” or owned by an HFT firm or a broker) and where everyone else has to fight to get it.

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    • Thanks for the comment, Mike. A couple thoughts:

      First, payment for order flow agreements usually specify that the receiver of the flow (the HFT) must pay at least the NBBO for the shares received. So retail traders aren’t disadvantaged by the agreement – HFTs prefer to pay brokerage houses for the chance to interact with the retail orders, rather than spend yet more $$ on technology to win the foot race of the open order book. I don’t know about you, but when I submit marketable limit orders on my retail brokerage accounts, I am almost always price-improved: if the NBBO was 100.00 x 100.01 when I submit an order to buy @ 100.01, I will get filled at something like 100.006. If I prefer not to use the PFOF model, I can direct my orders to a specific exchange, like you mentioned: though I can’t do this with TDA, I can do this with other brokers (e.g. Interactive Brokers). If you want your order ‘lit’, without HFT interaction, you can always choose this method.

      Second, the idea of the schoolyard bully isn’t the way I see market makers. As an individual trader myself (no, I don’t work for an HFT, though I did in the past), I first and foremost want someone there to take the other side of my trade. I can’t reasonably expect the market to function well without a market maker of some sort; these guys need the bid/ask spread to make it worth their while. As to stealing lunch money, I’d consider it more of a service paid for. One of my ideas in the original post was to decrease tick sizes, which should lead to tighter bid/ask and therefore less money on the table for the market maker; I reckon HFT can still make the biz model work with, say, 25% of the current tick size.

      On the Schwab point – I still find it amazing that a company which receives so much PFOF from HFTs wants to skewer them in public so much. It is agreements like PFOF that allow Schwab to offer cheaper commissions, etc. As a counter-example, I note that the brokers you mention are all considerably cheaper on a services-rendered basis compared with the brokers I use in the UK. The fact HFT/PFOF hasn’t really taken off in the UK might be a reason, but I’m not sure…

      Thanks again for the comment!

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      • Mike says:

        Well you are equating HFT with market making and I dont believe that to be accurate. A market maker has certain obligations to fulfill, such as maintaining a minimum bid-ask spread and depth at all times. In exchange for this service, they get afforded *the possibility* to make the spread and are granted certain privileges and tax treatments and god knows what else I forget. Certainly in some products HFT is a bonafide designated market maker but I would argue in most products they are just extremely active traders and if things go haywire they just turn off. Turning off is fine but thats not being a market maker. And I challenge your assertion we even need market makers. Im active in futures and have been for going on 12 years now. There are no market makers in the ES or FESX, both heavily traded. Market width is and has always been 1 tick wide, the minimum allowed by the exchange. Both markets are extremely deep and have always been. Maybe in new or low volume products a market maker is needed but otherwise I dont believe so. But my overarching point is, HFTs arent “offering a service”. A byproduct of what they do provides service. I myself offer liquidity when I think the odds are heavily in my favor but I dont delude myself into thinking I am pious and providing a service. I only trade when I think I can make money, same as HFT.

        As for Schwab, yes I dont get it either. Im certainly not about to bash anyone who is paying my company hundreds of millions of dollars but I digress. I can tell you that Ive paid the same 7.99 stock commission at Fidelity ever since I set up my account over 8 years ago. Ive no doubt trading for fidelity has gotten cheaper over the past decade but show me where these savings have been passed on to the customer? As far as I can tell, payment for order flow is just free money for the brokerages. As for why brokerages are cheaper here than in UK, hmm not sure, but I noticed coca cola cost about twice as much in the UK. Or maybe its because the population and traving volumes are massively larger here affording economies of scale? It is possible HFT has nothing to do with whatever you said which may or not be true in the first place, right?

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  2. Good points, Mike. Thanks again for the insights.

    Regarding market making, I agree that super-liquid products such as ES have enough 2-sided volume to make market making redundant. The need for market makers to provide tight bid/ask 100% of the time isn’t quite correct – see the Flash Crash or 1987 for examples where conventional/HFT market makers didn’t step in when the market was crashing. But I think your point about low volume/new markets requiring market makers probably includes 99%+ of markets out there – ES is a huge outlier, in terms of volume. A counterexample is agricultural futures markets, where market makers play a huge role.

    As to where the $$ paid for PFOF to the brokerages goes – your guess is as good as mine. I’m basing my assumptions on personal experience with US and UK brokerage houses: US brokers offer a relative cornucopia of features/data/ordertypes/cash management/research/etc. for ‘free’ (i.e. commissions + PFOF), whereas these features simply aren’t available (or very expensive) for UK investors. The competitive environment must play a role in this, true. Tough to know how much of each is there.

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