Judging high-frequency trading

By Felix Salmon
July 29, 2009
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:

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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methods of approaching stock valuation such as fundamental and technical analysis have gone out of the window and been replaced by such arcane concepts as quant factors.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.


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The arguments for HFT are very similar to the arguments for insider trading. Insider trading quickly moves the market towards more efficient pricing, reflecting all public and non-public information.But saying that insider trading promotes efficiency misses the problem.Similarly, arguments that HFT provides liquidity.

Posted by fusion | Report as abusive

What is the total market trading volume/year, in $? The profits from HFT can be seen as a tax on all trades. I’ve long thought that a small transactions tax would kill all these short-term strategies. The capital markets are supposed to be about allocating capital. How can a trade, entered and exited the same day have any real influence on the capital position of a corporation? Do we need instantenous, within fraction of a percent pricing accuracy? Is there any way markets are actually ‘right’ when they work prices to that level?

Posted by winstongator | Report as abusive

Felix,HFT is not $100m a day, that is insane. GS reported equities trading revenues of $3 billion for the quarter. That includes derivatives, program trading, prime brokerage, etc. HFT market making is a tiny portion of that.

Posted by taxpayer | Report as abusive

having more frequent speed bumps like price limits would slow down algorithms that try to make people chase markets. the limits used to be smaller (2% downside and then expand to 4%). hft that link spdrs to the emini provide immediate benefit to participants by making the market tighter (and i’d add that to best financial innovation of the last ten years because those spreads are now a penny wide for a decent chunk of the day)

Posted by h | Report as abusive

If all the HFT is doing is trading based on publicly available information – ie. open orders – then it’s not front-running, and it shouldn’t be illegal, regardless of how fast, expensive, or sophisticated it is. Trading on public information faster than someone else can is something traders have always tried to do. Is it a tax on those who are slower? Yes, but that tax has always existed in one form or another, and I don’t think any regulation, no matter how well crafted, can abolish it. “Flash” orders are potentially a bit of a grey area, but my understanding is that people can opt in or out, so it’s hard to see who’s being harmed there either.

Posted by Nate | Report as abusive

You may have already covered this, but who is this profit being made off of? I hope I am not about to make a fool of myself (confidence: low), but if you buy a stock for $1.00 and quickly sell it again for $1.01, what happens to the person who bought the stock at $1.01? I don’t see how a closed system consisting of HFT can make money, on net, trading among itself … fresh money need to be injected into the system from somewhere, so the profit comes from the new entrants buying at the higher price. Isn’t that a bit like a ponzi scheme? The guy who bought at $1.01 sells it to somebody at $1.02, everybody is booking a profit from the fresh money being added to the total market (which, say, is now valued at $102bn, up from $101bn, with $1bn of now money having been invested) until the market turns, and it is the chumps who last stumped up that end up paying for all past profits. But now I’ve confused myself even more, because how does this differ from low frequency trading? oh dear, low confidence was justified.what I meant to ask, is what extent are HFT making money by causing low frequency traders to make less?

Posted by Luis Enrique | Report as abusive

Why does increased index volatility neccesarily mean that the market is growing less efficient? As I’ve been taught, market efficiency means the rapid incorporation of all available information into the price of an asset. Huge structural changes to the real economy have taken place over the last two years, so why shouldn’t volatility have increased (as the new information to be incorporated has increased)?

Posted by James | Report as abusive

fusion makes a great point with the analogy to insider trading.Here is a strategy that very few understand, almost certainly not the regulators, and is used heavily by Goldman Sachs, et al., to make big profits.That Zero Hedge guy is borderline paranoid, but you’d need to be pretty naive to believe they make this profit purely by innocently providing liquidity.

Posted by Bob_in_MA | Report as abusive

You should have noted in your post that Cowen specifically excludes approval of such practices as tricking people into revealing strategy and then canceling. You are talking about a pure high frequency trading operation that is, it seems, fairly similar to the various volume trading strategies that came into use quite a long time ago but hopped up on steroids. Regulation of that has a different tinge because then the SEC et al have to judge such things as the quality of the liquidity, the availability of market information widely or not – with small differences being meaningful, whether stocks are being shorted nakedly, etc.The outrage over the strategy is twofold. First is the moral aspect highlighted by the details – especially as described in the Opinionator column – because those practices are morally indefensible. They are a form of thieving. Second, on top of all that’s happened, we have a few large houses that are using their connections to the marketplaces to take advantage of everyone else. That smells bad – why are they allowed to place so many orders so fast and why are they so directly connected because again that smells like stealing? More than that, as you note, it is not public policy, at least as articulated in public, to enable the markets to favor a few large houses in this manner.

Posted by jonathan | Report as abusive

“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.”I agree completely. There’s too much of the following in this issue:”it still looks like net liquidity to me”That’s not a terribly compelling bottom line. As for this:”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.”If this is true, I think that we have reason to worry, and should try to get back to such basic investing, which can include the govt intervening to produce this result. At the very least, the fuzziness of the issue is troubling. I can already here someone saying, “It was more complex than I thought.”

My understanding is that some firms get access to orders in advance of the “public”. Even though one may argue that this information is available to anyone willing to pay the “fee,” I don’t see this as any different from a CEO auctioning off advance information to the highest bidder.Why is one illegal and the other not?Secondly, if, as was noted in some articles, these trading programs can in essence create a “false” market to sniff out other’s price thresholds, why isn’t this illegal?This is not my area of expertise, but it sure fails the “if it quacks like a duck ” test.

Posted by Rockfish | Report as abusive

Slipping into the que at the front, all of the time, is not a random event but one that is manufactured.Just because one can do this is not sufficient reason to allow it. Particularly in what is supposed to be a free market where all honest participants are protected from manipulation.Under Bush the SEC disgraced itself by looking the other way. I was hoping Obama’s SEC would end such obvious manipulation of what is supposed to be a level playing field.

Having just read Paul Wilmott’s article he claims the major concern with HFT is the number of institutions all doing/not doing the same process at the same time.If this is a concern then the nubmer of banks using the same VaR method must also be a major concern. Using the same historical data set and the same number of standard deviations to adhere to regulatory authorities risk measurements causes a similar issue. All selling when the market is going down and all buying when the market is going up.The VaR issue makes the HFT issue as raised by Wilmott pale in comparison.

Posted by Peter | Report as abusive

Here I have to agree with ZH–The high-frequency shenanigans of the GSs of the world are driving me out, and I’ve been investing in stocks for four decades. HFT–and more specifically, front running–combined with a growing multitude of other deceptive and corrupt business practices among the exchanges, the principal traders, and the companies that I could be investing in all turn strategic stock investment into a sucker’s game for the little guy.I don’t need it. When the SEC, CFTC, etc ad nauseam, can bring transparency, a level playing field, and integrity to the markets and the companies in them, I’ll consider re-entering.

Posted by Lilguy | Report as abusive

Your $100mm/day figure for GS is way off. They made approximately this much off ALL their proprietary trading operations, but not HFT alone.Also, once you quoted ZeroHedge, your credibility went down to practically zero. Have you read that site? It’s a bunch of novice investors looking for conspiracy theories in every single market event.

Posted by Rob | Report as abusive

There’s a lot of confusion and misinformation out there re: what is HFT. First of all, HFT isn’t based on flash orders. Flash orders are an order type, and it’s pretty useless to most HFTs unless you’re a rebate trader in super-tight spread stocks. It’s true that it’s a way to remain complaint with reg NMS. Also, co-located computers don’t see orders BEFORE they hit the market, and don’t front-run, they just get the public data faster than higher-latency strategies, though for a long-term investor, the latency is meaningless. If you want to point fingers at those who see order before the public, look no further than specialists on the NYSE! They absolutely trade based on what they see in their book, all in the name of “providing a fair and orderly market”. What’s fair about that?If it’s true that HFTs represent 70% of volume (based on what NYT article says), if you take out that volume, what do you think that will do to spreads? It’s very interesting to note that some of the biggest opponents of HFT (like Joe Saluzzi of Themis Trading) stand the most to gain if spreads get bigger again.If a widely used strategy poses a systemic threat, it should most definitely be looked into; however, most HFTs have competing strategies with varying timescales, and pretty much just make/lose money amongst each other, not off the “little guy”. If GS is watching their customer orders come in and making trades ahead of those, that’s a completely different issue, and they should most certainly be punished for that.Let’s put our pitchforks down and stop trying to find a villain. I think we can all agree that everyone in the country played a role in the economic state in which we currently find ourselves. People spent money they didn’t have, bought houses they couldn’t afford, and now want someone to blame. Look in the mirror, stop whining, and be productive.

Posted by PG | Report as abusive

Felix Solomon is a moron. The HF trade generated 20 billion last year however stating that GS is twenty percent of the market shows how misinformed he is. In terms of prop HF (which most of the P&L is generated from), GS was not even a top ten player. Rentec, Getco, Citadel, Tower, and Quantlab accounted for at least a third of the total figure.Also, I find it fascinating that Felix and others are crucifying HFT this year. The trade is off by at least thirty percent (across asset classes), if not more. It has become overcrowded and guys are cutting into each others profit margin (just like stat arb five or six years ago)In terms of long term investors, please define long term? Amazon, Apple, and a variety of other well run companies have performed well over the past few years. Good companies have good performance. Just because one invests in a stock that they believe is a good long term play, does not mean it is a good long term play. If you want guaranteed returns, start buying munis and quit complaining.

Posted by ZT | Report as abusive

explain to me what would be wrong with limiting all trading intervals to 10-seconds, thereby tossing maybe 10-25% of investment banking employees out on the street, and eliminating a large tax on small investor profits?

Posted by david | Report as abusive

If HFT generates such a high percentage of all trading, that’s an argument for restricting it. This gets back to the liquidity argument because that form of liquidity is mostly an illusion which gives the impression that spreads are small, which misleads about real levels of demand, risk, etc.

Posted by jonathan | Report as abusive

it’s not hft that poses the risk. it’s fi’s using flash orders as part of their hft (to allow these traders to front run) that poses the risk to the capital markets and to all investors.the ny ag needs to get involved and subpeona for transactional data because there is a risk of white-collar crime involved. can’t leave this issue solely to the SEC because they have a terrrible track record (i.e. Madoff, Stanford, ratings agencies, MBS).at a minimum, two things need to happen: 1) fi servers need to be moved outside of the exchanges (can’t be convinced that the loss of a couple of seconds will seriously deteriorate liquidity), and 2) exchanges should not be allowed to police compliance on this issue (they have a financial stake in hft and thus have a conflict of interest).

Posted by MF | Report as abusive

Are you all morons? You can limit HFT in time limits and taxes. The problem is you will kill the markets!Market makers and HFT in general makes tha market more efficient and killing them will make them a lot less efficient and drive retail investors out to trade in other countries where stupid rules do not exist.

Posted by Trader | Report as abusive

As if they had any other choice but to clamp down on it! Most people don’t know exactly how flash trading works yet they still clearly need someone to blame for why things are so bad right now. Because all these people can’t seem to finger the real culprit (the gov’t) due to obesity, food additives, apathy, the un-education of America, 150 milltion of them on pharmaceuticals, 30 milltion on food stamps, 30 million on anti-depressants, and 4 million in prison (fed+state+county)……… I guess they’ll have to slap somebody on the wrist for pillaging their 401k’s and feel REALLY good about getting the “bad guy” just like an old John Wayne movie.How does program trading work? Check it out. Are you ready? A New Era Begins…..http://www.youtube.com/watch?v= VRhyWZnGjyc

HFT is actually very easy to understand. It’s providing liquidity. People make it into this crazy buck rogers thing, but it ain’t. If you want to learn something about it, Larry Harris’ book is a good one.

High-frequency trading will improve market liquidity as there are always buyers or sellers available in the market when the investors want to trade.

This and other topics that are relevant for speed traders and institutional investors will be discussed at High-Frequency Trading Leaders Forum 2013 London, next Thursday March 21.

Posted by EllieKim | Report as abusive