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Financial markets

The Economist Debate: High-frequency trading


This house believes that high-frequency trading contributes to the overall quality of markets
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Representing the sides

Defending the motion

Jim Overdahl: Vice-president, Securities and Finance Practice, National Economic Research Associates
Opening:

High-frequency trading has improved the overall quality of markets. Trading costs are lower, markets are deeper and more liquid, discrepancies in prices across related markets are reduced, and prices better reflect information about the value of stocks and commodities.

There has been a lot of confusion about the meaning of the term “high-frequency trading”. It has become a catch-all phrase that captures many elements. I think of high-frequency trading as describing a wide variety of automated trading strategies that use computers to generate, submit, monitor and revise buy and sell orders continuously throughout the trading day. These strategies are based on decision rules programmed by humans and use publicly available information. High-frequency trading is used by a wide variety of professional traders, including investment funds and investment banks, traditional market making firms and proprietary trading firms. High-frequency trading has emerged as the result of innovations in trading technology coupled with reforms in trading regulation that have made markets more open, competitive and transparent.

A growing body of academic work shows that high-frequency trading has improved the overall quality of markets. Market quality metrics across the board have improved as trading has become more automated and competitive. Trading costs are lower, markets are deeper and more liquid, discrepancies in prices across related markets are reduced, and prices better reflect information about the value of stocks and commodities.

One way high-frequency trading improves the quality of markets is by improving the efficiency of those professional traders who bridge the gaps between natural buyers and sellers who may not be in the marketplace at exactly the same time. For these professional traders, high-speed order entry is an essential risk management tool that permits them to revise orders quickly in response to real-time information about market conditions. By being able to manage risk more efficiently, professional traders are able to offer narrower bid-ask spreads, and quotes for larger size, resulting in lower cost, and more liquid markets, for end users. High-frequency trading is simply an extension of the same types of risk management tools that market makers have traditionally deployed to manage risks that are always present in markets, such as the risk of having their open orders hit by traders with superior information about pending order flow or significant news.

Another way high-frequency trading contributes to the overall quality of markets is by strengthening the informational linkages between related markets. High-frequency trading techniques ensure that prices between related products and markets stay in close synchronisation. Any discrepancies in prices are quickly traded upon, restoring prices to their proper alignment. By facilitating efficient arbitrage between related products and markets, high-frequency trading contributes to the overall quality of market prices.

Although high-frequency trading techniques are used primarily by professional traders, all market participants, including average investors, benefit from their use. For example, take a long-term buy-and-hold investor holding a mutual fund. How does high-frequency trading benefit this investor? The answer is that the intense competition between high-frequency traders reduces the transaction costs incurred by the mutual fund. As a result, the investor has less money taken out of his account to cover those costs and ends up with a higher investment return. The Vanguard Group, a mutual fund company that does not itself use high-frequency trading techniques, has advised regulators that in their view high-frequency trading has resulted in significant cost savings for long-term mutual fund investors.

Although high-frequency trading has contributed to overall market quality, important work remains to be done to strengthen trading infrastructure. In particular, the flash crash of May 6th 2010 exposed market infrastructure issues that regulators have since worked hard to address. For example, the SEC-CFTC staff report on the flash crash notes that one reason some market participants withdrew from the market was because of uncertainty about which trades would be cancelled. For many traders, confusion about which trades would stand created unacceptable risk, leaving firms exposed to the possibility that risk-neutral positions would suddenly be transformed into risky positions. The SEC has acted to address this uncertainty by better coordinating policies for cancelling clearly erroneous trades. In addition, improvements in market infrastructure can result from implementing best practices for real-time risk controls, and giving regulators the tools they need to police the market against abuse. Regulators seeking to improve market infrastructure must take care that their actions will preserve the market quality improvements that have occurred as markets have become more automated and competitive.

High-frequency trading, like any trading tool, can be abused. However, it would be unfair to attribute these abuses to the technology itself, since abuse can occur with any trading tool in any trading environment. When market abuse occurs it should be detected and violators should be punished. Modern markets with precise, permanent electronic audit trails increase the probability of detecting abuse, and are therefore arguably less subject to abuse than manual markets of previous eras.

In sum, high-frequency trading has contributed to the overall quality of markets. This conclusion is best demonstrated by the strong empirical findings found in the academic literature. Moreover, all market participants have benefited from these improvements in market quality, not just the professional traders responsible for bringing these improvements about.

Rebuttal:

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Against the motion

Seth Merrin: Founder and CEO, Liquidnet

Opening:

High-frequency traders are, by design, trading ahead of market orders to the detriment of long-term investors. HFT benefits the very few at the expense of the very many, which defies the purpose of why a market exists and as a result has lessened the overall quality of the markets.

The last few years can only be characterised as market chaos where market confidence has been mortally wounded. Along with the macroeconomic issues, what we saw was a market of intense volatility where Main Street investors, who number 90 million strong, pulled their money out of equities and either put it in their mattresses or into low-yielding instruments. While a number of factors were at play, the growing role of high-frequency trading and its ability to take advantage of the volatility and inefficiencies in the market cannot be dismissed.

One only has to look back a few short years when the market was comprised primarily of two groups—institutional investors who invest on behalf of Main Street Investors—and retail investors, both of which were focused on investing fundamentals. Today, the markets are split between the fundamental investors, and the “valuation agnostic” high-speed traders who buy or sell stock in a way that is completely disconnected from the underlying value and fundamentals of the company.

The most popular form of high-frequency trading is momentum-type arbitrage whereby traders look for catalysts from large institutional orders in the market. Every day money managers bring orders to buy or sell hundreds of thousands of shares to trading venues that specialise in executing orders of just a few hundred. This in turn presents, virtually with every trade, an imbalance of supply and demand that the high-frequency trader preys upon. Ultimately, this is bad news for everyday investors.

Research from Quantitative Services Group suggests that during a high-frequency buying spree, block order prices can jump by as much as 40 basis points. In this zero sum game, the 40 basis points represents a very good return for few but comes at the expense of the 90 million people who invest their savings with professional money managers.

Investing in equities has historically proven to be one of the best investments over time and an important component in asset allocation. A significant number of Americans have relied on equities to fund their retirement plans. Individuals need confidence that equities are a safe investment class and that their interests will be protected. And while the economy is cyclical, the trend in volume of high-frequency trading is not—and is, indeed, worrying.

It is not surprising that of the more than 630 global asset management firms that Liquidnet polled in a recent survey, more than two-thirds of respondents were concerned about the impact of high-frequency trading on the equities market. In the UK, a poll for a UK government-sponsored study of UK equity markets by Professor John Kay showed that a majority of British asset managers, pension funds and corporate treasurers are skeptical that high-frequency trading actually provides additional liquidity to markets.

Regulators around the world have taken note. As the Securities and Exchange Commission’s (SEC) chairman, Mary Schapiro, has said, a large portion of equities trading has little to do with “the fundamentals of the company that is being traded”. And with an estimated 95-98% of orders submitted by high-frequency traders ending up getting cancelled, it refutes the argument of high-frequency trading providing liquidity to the markets.

If we are to rejuvenate and bring quality back to our markets, the individual investor needs a safe haven for their equity investments, not from the risk associated with stock performance, but the ever present risk so prevalent in the actual everyday trading of stocks. There are global trading networks such as Liquidnet that were founded on protecting investor order flow from market predators and market impact, information leakage and eliminating the supply/demand imbalance that is the catalyst driving high-frequency trading. But more often than not, orders are directed to other brokers where high-frequency traders proliferate. There are incentives to direct order flow, but none should be as strong and compelling as ensuring the interests of every person with a pension fund are protected.

At the end of the day, high-frequency traders are not doing anything illegal or immoral, but they are, by design, trading ahead of market orders to the detriment of long-term investors and the 90 million people they represent. High-frequency trading benefits the very few at the expense of the very many, which defies the purpose of why a market exists and as a result has lessened the overall quality of the markets.

Rebuttal:

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Moderator

Opening:

The flash crash of May 2010, when American equity markets nosedived by almost 10% in the course of a few nerve-shredding minutes, focused popular attention on the role of algorithmic trading, and in particular, on ultra-fast high-frequency traders (HFTs). Such traders have lots of different strategies but they are characterised by very active trading, very brief holding periods and blinding speed: in some places, transactions are now being executed in microseconds, or millionths of one second.

High-frequency trading is increasingly important to the fabric of markets. Estimates vary but there is consensus that a majority of American equity-market trades are down to HFTs. Their share of equity transactions in emerging markets is rising rapidly. The speed merchants are also present in other markets. A 2011 report by the Bank for International Settlements suggested that HFTs made up around 25% of spot trades in the vast foreign-exchange market, for instance. Over the longer term, many expect them to find their way into over-the-counter derivatives markets.

But equity markets are where attention—and therefore this debate—is focused. Today’s stockmarkets are perceived by some to be more like science fiction than a device for the efficient allocation of capital. Critics argue that high-frequency trading does nothing more than gouge slower-moving investors, add to market volatility and risk future flash crashes.

Speaking last month, Mary Schapiro, the chairman of America’s Securities and Exchange Commission (SEC), expressed her own concerns about high-frequency trading. “It’s got very little to do with whether you think IBM’s got a great business plan and solid earnings growth in its future,” she said, “and a lot more to do with what’s the minuscule aberrational price move that you can take advantage of because you’ve co-located your computer with the exchange and can jump on that in microseconds.” Plenty in Europe share these worries. Plans by European policymakers to impose a financial-transactions tax are driven in part by a desire to reduce the volume of high-frequency trading.

Defending the motion is Jim Overdahl, himself a former chief economist of the SEC and now the vice-president of NERA, an economic consultancy, and an adviser for the Principal Traders Group of the Futures Industry Association. In his opening statement Mr Overdahl argues that high-frequency trading improves the quality of markets by enabling market makers to manage risks more efficiently, leading to narrower costs for investors; and by ensuring that price discrepancies between different markets are quickly traded away. He acknowledges that more needs to be done to strengthen the infrastructure of markets, but points to academic research showing that transactions have become cheaper, markets more liquid and prices more accurate as markets have become more automated.

Seth Merrin, the founder and chief executive of Liquidnet, a trading network for institutional investors, opposes the motion. In his opening statement Mr Merrin argues that HFTs prey upon institutional investors when they make large trades, and cites research showing that a majority of asset managers and pension funds are sceptical about the liquidity advantages that high-frequency trading is supposed to bring. He does not accuse high-speed traders of doing anything illegal or immoral, but argues that their ability to trade ahead of long-term investors means that the markets benefit the few, not the many.

In her remarks last month Ms Schapiro of the SEC said that regulators lack enough data to really know what impact HFTs have on the markets. This debate may not solve that problem, but I hope it will contribute to a better understanding of the issues raised by high-frequency trading. That will depend not just on the persuasiveness of our guests but also on your own participation, so please do vote on the motion and make your own views heard with your comments.

Rebuttal:

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