Swedroe: High Frequency Trading & Price Efficiency

The effect of high-frequency trading on market quality has generated strong interest among academics, investors and regulators alike.

To further explore the impact high-frequency trading can have on the markets, Jennifer Conrad, Sunil Wahal and Jin Xiang—authors of the study “High Frequency Quoting, Trading, and the Efficiency of Prices”—conducted two types of tests: (a) unconditional tests, which were designed to provide evidence for a comprehensive cross section of securities over an extended and relatively recent time series; and (b) conditional tests, which measure the effect of high-frequency traders (HFTs) under different types of market conditions and across changes in market structure.

The second test examines both “average” and stressed market environments. This is important because a common complaint about HFTs is that they have made the market more fragile, at least insofar as the price of liquidity rises too rapidly (or that liquidity disappears entirely) just when traders need it most (such as during the “flash crash”).

2 Largest Equity Markets Used

The data sample in the study, which was published in the May 2015 issue of the Journal of Financial Economics, comes from the two largest equity markets in the world: the full cross section of securities in the United States and the largest 300 stocks on the Tokyo Stock Exchange. The authors’ sample period is from 2009 through 2011 for the U.S. and from 2010 through 2011 for Japan. The following is a summary of their findings:

• More frequent pricing updates are associated with lower costs of trading. Controlling for firm size and trading activity, average effective spreads are lower for stocks with higher quote updates by 0.5 to 6 basis points.
• The magnitude of the effect that higher-frequency updates produce on market metrics appears to be economically meaningful. Increases in the number of updates represent more than simply the addition of noisy data that must be processed and filtered out to assess market conditions.
• High-speed updates represent the provision of liquidity and, on average, allow for information to be reflected in prices.
• While it’s not a surprise that during episodes of market stress both buyer- and seller-initiated drawdowns can incur substantial costs, drawdowns in securities with higher updates incur lower costs, consistent with the idea that updates are correlated with liquidity provision. There’s no evidence that effective spreads increase after large buyer- or seller-initiated liquidity drawdowns. On average, the market appears resilient.

Unique Opportunity

A change in systems in the Japanese market provided a unique opportunity to test the impact of HFTs. On Jan. 4, 2010, the Tokyo Stock Exchange replaced its existing trading infrastructure with a new system (Arrowhead) that reduced the time from order receipt to posting/execution from one to two seconds to less than 10 milliseconds.

The authors found that effective spreads declined by roughly 10 percent on the date the new trading system was introduced. They state: “Overall, the data suggest that facilitation of high frequency quotation has, on net, beneficial effects in the second largest equity market in the world.”

Price Discovery Improvements

From this, Conrad, Wahal and Xiang concluded: “The evidence suggests that, on average, high frequency quotation activity does not damage market quality. In fact, the presence of high frequency quotes is associated with improvements in the efficiency of the price discovery process and reductions in the cost of trading. Even when high frequency trading is associated with large extractions of liquidity in individual securities, the price process in those securities appears to be quite resilient.”

They add: “The data broadly show that the electronic trading market place is liquid and, on average, serves investors well.”

However, the authors do provide some notes of caution. They write: “Although the evidence suggests that high frequency activity is associated with some improvements in the market’s function, the results do not imply that the market always functions in this way. An obvious case in point is the “Flash Crash.” Practitioners also refer to ‘mini-crashes’ in individual securities in which there are substantial increases or decreases in prices as liquidity disappears and market orders result in dramatic price changes. While dislocations are harmful to market integrity, it is important to recognize that some discontinuities have always occurred in markets (even before the age of electronic trading).”

Benefiting From Tighter Spreads

While the financial media has been filled with concerns about the impact high-frequency traders have had on the markets, it’s interesting to note few of the complaints come from the fund families that tend to be liquidity providers and patient traders.

This group includes firms such as Dimensional Fund Advisors and AQR Capital Management. Neither is a high frequency trader. (Full disclosure: My firm, Buckingham, recommends Dimensional and AQR funds in constructing client portfolios.)

In my discussions with them, both firms have indicated they believe their trading costs have come down, benefiting from tighter spreads. Furthermore, Vanguard has defended HFTs. In an April 2014 interview with the Financial Times, Bill McNabb, the firm’s chief executive officer, said that HFT firms had helped investors cut their trading costs, and he urged the U.S. Securities and Exchange Commission not to reverse the market reforms that gave birth to the phenomenon.

It’s the large, active fund managers that are the ones you often hear complaining the most. While bid/offer spreads have come down—which helps reduce costs for patient traders—the depth of the markets (the ability to move large blocks of stock with low trading costs) has decreased.

This occurs because the once-large bid/offer spreads that provided sizable profit opportunities for market makers—enticing them to take risks by providing liquidity—have narrowed. So what helps the patient trader hurts those that demand large liquidity.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.