Judging high-frequency trading
There’s an interesting debate in the comments to my post on high frequency trading about the widely-cited $20 billion figure for the profits attributable to HFT. In Jon Stokes’s Ars Technica article on the subject, he writes this:
At least two different groups, the TABB Group and FIXProtocol, estimate that high-frequency trading generated around $20 billion in profits for the financial sector last year. Goldman Sachs accounts for some 20 percent of global high-frequency trading activity, and the bank recently had a blow-out quarter in which its HFT-heavy trading operation racked up a record number of days where profits topped $100 million.
If Goldman Sachs alone can make $100 million a day from HFT, then $20 billion globally seems reasonable. But that’s a very big if, and I’d love to see how TABB Group and FIXProtocol arrived at their figures. (It would also be nice if HFT was clearly defined, which it isn’t, although I think most people agree that it’s a superset of flash trading.)
Elsewhere, Paul Wilmott (con) and Tyler Cowen (pro) join the debate. I’m more convinced by Wilmott than Cowen, although both make good points: Wilmott says that the complex algorithms driving HFT are prone to spectacular failure, while Cowen notes that “the correct judgment of efficiency occurs at the system-wide level, not at the level of the individual trading strategy”.
To that point, I’d be inclined to think that the massive volatility we’ve seen in the stock market of late is an indication that it’s not getting any more efficient, and therefore that it’s entirely plausible that HFT is hurting efficiency. Zero Hedge (now with its own domain name) puts the case in its strongest form:
Long-term buy and hold investors have already departed the market, as they have realized the traditional methods of approaching stock valuation such as fundamental and technical analysis have gone out of the window and been replaced by such arcane concepts as quant factors.
I think that’s overstating things, but even if it’s only true at the margin, it’s still a negative development.
At heart, the debate comes down to liquidity: is HFT a good thing or a bad thing, from a liquidity perspective? Cowen thinks it’s a good thing:
High-frequency trading brings more liquidity into the market. Call it “low quality liquidity” if you wish, but it still looks like net liquidity to me.
I don’t think that case is proven, although again the term “liquidity” is vague enough that it’s important to be able to define terms here. I think the important sense of liquidity is not narrow bid-offer spreads, but rather the ease of doing big deals at the market price, and/or the ability to buy or sell stock without moving the market. In that sense, HFT hurts, rather than helps: every time anybody tries to buy anything, the predatory algos try to pick them off. If that makespeople more reluctant to trade (“if you don’t like it, you can trade yourself at much lower frequencies”, says Cowen) then that ultimately hurts price discovery and transparency.
My bottom line is that HFT is a black box which very few people understand, and that one thing we’ve learned over the course of the crisis is that if there’s a financial innovation which doesn’t make a lot of sense and which is hard to understand, there’s a good chance there’s systemic risk there. Is it possible that HFT is entirely benign and just provides liquidity to the market? Yes. But that seems improbable to me.