An Illuminating Contrast: High Frequency Traders Are Not Sunshine Soldiers

High frequency trading firms came under heavy fire in the aftermath of the May 2010 Flash Crash because they largely withdrew from the market shortly before the Crash.  Indeed, the lack of liquidity (which is nowadays largely provided by HFT firms) was likely a necessary condition for the Crash to occur.

In light of that, and of last week’s market craziness, it is therefore quite interesting to read this:

The stock market’s fastest electronic firms boosted trading threefold during the rout that erased $2.2 trillion from U.S. equity values, stepping up strategies that profit from volatility, according to one of their biggest brokers.

The increase from Aug. 1 to Aug. 10 over their 2011 average surpassed the 80 percent rise in U.S. equity volume, showing that high-frequency traders made up more of the market during the plunge, Gary Wedbush, executive vice president and head of capital markets at Wedbush Securities, said in a telephone interview. Wedbush is the largest broker supplying bids and offers on the Nasdaq Stock Market, according to exchange data.

“We’re seeing a tremendous amount of high-frequency trading,” said Wedbush, whose company is one of the biggest execution and clearing brokers catering to high-speed firms. “Their business is a trading business, and volatility creates far more opportunities. Some of their algorithms and automated systems are trading two, three or five times as many shares as they would have in a more normalized volatility environment.”

It is therefore incorrect to say that HFT firms are Sunshine Liquidity Suppliers who head for the hills when things get volatile.  Sometimes HFT reduce the amount of liquidity they supply.  Sometimes they increase it.  And volatility alone is not enough to spook HFT firms.  Indeed–and this shouldn’t be surprising, really–volatility can be a huge profit opportunity for them.  Note, moreover, that their profit-spurred entry almost certainly reduces volatility below what it would be otherwise and improves efficiency.

One should hope, therefore, that regulators and others who blame HFT for every market outcome they don’t like will take this more recent experience into account in order to develop a more mature understanding of HFT, and use that understanding to develop sensible policies that encourage beneficial HFT.  Policies that don’t throw the baby out with the bath.

A study of what caused the differences between the first two weeks of August and the Flash Crash could be quite illuminating.  Market making, whether old school on the floor of an exchange or new school on computer at high speed, is vulnerable to toxic order flow–that is, order flow driven by private information.  Any market maker who wants to survive has to have the ability to determine when order flow is toxic and when it is not.  Old school traders could intuit the likelihood that the guy who wanted to buy from or sell to them was trying to pick them off because he had better information.  HFT uses algorithms to try to sniff out such opportunistic order flow.

It is pretty clear that on May 6, 2010 HFT algos were flashing warning signs that the order flow had turned toxic,  and they cut back as a result.  It is also clear that despite all the volatility in these days of Downgrade and Debt Crises, the algos are not picking up evidence of an increased intensity of privately-informed trading.  As a result, the HFT firms are sufficiently confident that the risk of being picked off is low that they can profitably supply liquidity.

One interpretation of this is that HFT firms are primarily responding to market conditions, rather than creating them.  One implication of this is that regulators should try to develop tools that would allow them to pick up the same warning signals that HFT algos do in order to anticipate potential market disruptions a la 6 May 2010.  This would permit the implementation of precautionary policies that could reduce the likelihood and intensity of Flash Crashes.  This would be a far better policy than micromanaging HFT trading through things like order time limits or commitments to make markets even when that is unprofitable.  Micromanagement is likely to be counterproductive as it raises the costs of supplying liquidity, and inducing exit of market making capital–which would make prices more volatile during conditions like those that have prevailed this month.

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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