The effect of high-frequency trading (HFT) on market quality is important, and has generated strong interest among academics, investors and regulators alike.
Graham Partington, Richard Philip and Amy Kwan—authors of an October 2015 paper, “Is High Frequency Trading Beneficial to Market Quality?”—examined how HFT has changed the dynamics of the market and whether traditional academic measures of market “quality” are relevant in the new world of electronic trading.
To answer the question of whether HFT has been beneficial to trading, we first need to define what we mean by “market quality.” Larry Harris, author of the book “Trading and Exchanges: Market Microstructure for Practitioners,” argued that the highest priority of financial markets is to promote the interests of “utilitarian” traders (the traders whose needs cause the markets to exist in the first place). A large portion of these utilitarian traders are institutional investors.
At the lower end of the priority spectrum are the interests of traders seeking profits from trading rather than investment. Their interests should only be supported when necessary to achieve other objectives, such as providing liquidity.
On the other hand, there’s a class of trader that Harris suggested markets should be hostile toward, specifically those who design trading strategies with the sole purpose of exploiting other traders. It’s possible that HFT falls into both these categories.
Does HFT Help Or Hurt Markets?
Partington, Philip and Kwan define HFT as “a fully automated proprietary trading strategy which executes multiple intraday trades for profit.” They differentiate HFT from algorithmic trading (AT) in the following way: “HFT strategies are designed to determine when a profitable trade should be made, whereas AT is about determining how to execute a large order so as to minimise market impact.” The emphasis is mine. The strategies and objectives are clearly different.
There has been much attention from the financial media on the negative effects of HFT. However, studies have also suggested that HFT is beneficial to market quality by providing liquidity and reducing the bid/ask spread.
For example, Jennifer Conrad, Sunil Wahal and Jin Xiang—authors of the study “High-Frequency Quoting, Trading, and the Efficiency of Prices,” published in the May 2015 issue of the Journal of Financial Economics—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 go on to add: “The data broadly show that the electronic trading market place is liquid and, on average, serves investors well.”
However, Partington, Philip and Kwan note that while “tighter spreads are generally considered beneficial to market quality … there are trading strategies which will result in a tighter spread, but which are detrimental to the interest of institutional investors. One example is the strategy of front running or penny jumping … which adds nothing to market quality, yet will improve the bid/ask spread metric.”
They also note that “supplying liquidity on the thick side of the order book is of little value, as there is already a surplus there. The real value is supplying liquidity on the thin side of the order book, where it is most needed.”
Unfortunately, they find that HFT supplies liquidity where it is least needed—on what is already the thick side of the order book. They cite research showing that “depending on the size of the order, the impact when non-HFT orders are removed is between 3 and 15 times larger than the impact when HFT orders are removed. This is attributed to non-HFTs supplying much more depth in the order book.”
The authors also examined the research on the impact of HFT on volatility and concluded that the research is inconclusive, with some evidence on both sides. However, when it comes to the issue of providing liquidity, the research shows that HFT supplies “roughly the same amount of liquidity” as it takes. Yet HFT extracts approximately $3 billion annually while doing so. The authors do note that not all HFT is detrimental to market quality.
Using data from the Australian Securities Exchange that covered the period Jan. 1, 2009 to Aug. 27, 2013, Partington, Philip and Kwan provided new evidence by examining whether HFT tended to provide liquidity on the thick side (where it’s needed least) or the thin side (where it’s needed most) of the order book.
To find the answer, they computed both the probability of filling and the expected time to fill institutional orders. They found that “as HFT has become more prevalent an institutional investor’s limit order becomes less likely to execute … . At the beginning of the sample period an institutional investor’s limit order is expected to execute more than 50% of the time, whereas by the end of the sample, the expected probability of execution has decreased to 30%.”
The authors also found that “as HFT has become more prevalent … the time an institutional investor must wait for their limit order to execute has increased.” They then conclude that the data is “consistent with institutional investors being squeezed out from the limit order book by HFT traders, evidenced by the fact institutions now face longer waiting times for order execution and there is less chance of an order being executed.”
Specifically, Partington, Philip and Kwan found that in the most recent year, when HFT has been most prevalent, “the results for the top of book imbalance when HFTs demand liquidity shows that HFTs consistently use buy (sell) market orders when the volume on the bid (ask) is much larger than the volume on the ask (bid) ... . Whether it is front running, or seeking quick execution, the liquidity is supplied not where it is needed, but on the thick side of the order book.”
They also found that “non-HFTs have a larger proportion than HFTs of their trades on the thin side of the order book, thus supplying liquidity where it is most needed.”
In short, Partington, Philip and Kwan found that as HFT became more prevalent, the probability decreased that an institutional limit order would execute, and the average time taken for institutional order execution increased with HFT activity.
They write: “Taken together, these two findings suggest that institutional investors are crowded out from the order book in the presence of HFT. HFTs strongly demand liquidity on the thin side of the order book and are less generous in supplying liquidity on the side of the order book where it is most needed. The results are suggestive of HFT trading strategies that front run the limit orders of other traders.”
Active Managers Not HFT Fans
While the financial media has been filled with concerns and complaints about high-frequency traders, it’s interesting to note that you don’t hear any complaints from mutual fund families that tend to be liquidity providers and patient traders (firms such as Dimensional Fund Advisors and AQR Capital). Neither is a high-frequency trader. In my discussions with both firms, I’ve found that they believe their trading costs have actually come down, benefiting from tighter spreads. (Full disclosure: My firm, Buckingham, recommends Dimensional and AQR funds in constructing client portfolios.)
Additionally, Vanguard has defended HFTs. In an April 2014 interview with the Financial Times, Vanguard CEO Bill McNabb said that HFT firms had helped investors cut their trading costs, and 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 hear complaining. While bid/offer spreads have come down, helping to reduce costs for patient traders, the depth of the markets—the ability to move large blocks with low trading costs—has decreased.
The once-large bid/offer spreads that provided large 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.