The most recent controversy over HFT stems from this WSJ story about the CME. In a nutshell, computerized traders receive confirmations of their trades before information about those trades is disseminated to the market at large. As in a few milliseconds before. But in an electronic world, a few milliseconds can be decisive.
One example of a particularly informative trade is when an away-from-the-market limit order is executed. This means that a market order of sufficient size to blow through the quote size at the inside market was submitted. Given that orders and communicate information, and that the bigger the order, the more informative it is, knowing before anybody else that such an order has been executed can provide valuable information.
The implications of this depend on how the information is used. A trader (or, more accurately, a bot) that gets this information can use it to take liquidity aggressively. For instance, it can use information gleaned from a big, price-moving crude oil buy to submit an aggressive order in heating oil or RBOB, thereby picking off resting limit orders that cannot adjust to the new information. Or, as the WSJ article suggests, the bot can use the information derived from the NYMEX CL trade to take liquidity from ICE Brent or NYMEX lookalike futures.
This kind of trading exacerbates information asymmetries, and all else equal, increases spreads, reduces depth, and increases trading costs for the uninformed.
But the “all else equal” part of the statement doesn’t necessarily hold. This presumes that the amount of capital devoted to HFT is constant. But that’s not true in the long run. If these sorts of advantages generate profits, that will attract more capital into HFT. Moreover, note that the strategy just outlined involves placing limit orders, and then reacting when those limit orders are executed. Competition to get the information advantage will lead to more aggressive quotes, and quotes in bigger size. In the long run equilibrium, this competition will dissipate the rents from the information advantage.
Therefore, if there is any reason to reduce this speed advantage (either by slowing down some traders or speeding up the dissemination of trade execution information to the market at large), it is to prevent the investment of excessive capital into HFT. The effect on spreads and depth in equilibrium is ambiguous.
Moreover, there are other possible uses of the information advantage that are clearly socially beneficial. An HFT market maker-who is likely making markets in a variety of contracts-can utilize the information to revise limit orders either in the market in which the execution occurred, or in other markets, especially those that are closely related (again, consider the CL/HO or CL/RB example). Using the speed/information advantage in this way reduces the HFT market maker’s vulnerability to getting picked off, and makes it willing to supply liquidity more aggressively. This tends to reduce trading costs, and does not lead to the rent seeking that in the long run equilibrium tends to result in an inefficiently large HFT presence.
We also need some perspective here. I consider it beyond hilarious that the WSJ has a video embedded in the online version of the story that has many images from the floor. (And these days, one of the floor’s main functions is to provide visuals for stories on trading-especially the trader’s-head-in-his-hands shot on days when the market falls a lot. Pictures of servers aren’t nearly so dramatic.)
Why hilarious? Well, the floor was the epitome of time and space advantages to a select few. A select few who paid for the privilege. I remember distinctly a trader telling me: “Why do I spend $500,000 on a seat? Because I get to see the price before anybody else.”
Exactly. The floor was the meat version of colocation. Or the carbon based life form version, if you like. Those on the floor could see the execution prices, and bids and offers, and order flows, that those off the floor could not. They profited accordingly. Which is why the marginal guy on the floor-the least efficient trader-was willing to pay hundreds of thousands of dollars in some cases to get on the floor.
In 2002 or so I wrote a paper titled “Upstairs, Downstairs” (still a working paper) which showed that floor traders earned a rent as a result of their time and space advantage: upstairs traders could not supply liquidity as effectively as floor traders due to their information disadvantage, and this meant that floor traders faced limited competition in supplying liquidity. Moreover, exchange limits on membership meant that entry could not dissipate these rents. But by reducing the time disparities between liquidity suppliers advantage, electronic trading increased liquidity supply: upstairs traders were no longer operating under a time and space handicap. Trading costs and rents decline. And that decline in rents is precisely why floor traders fought electronic trading so fiercely for years.
So yes, in today’s electronic markets some traders have a speed advantage. But this disparity is nothing when compared to that which existed in the floor days.
Which is why I can’t really get all that spun up over the WSJ story, or most of the other stories about how unfair markets are. Everything is relative. No, the playing field isn’t perfectly level today, and along the lines of yesterday’s post, it may be in the interest of the CME to take measures to make it more level. They say that they are. But arguably the field is more level than it has ever been. It’s certainly far more level than in the heyday of the trading floors. Don’t get nostalgic for the days when market makers were meat, not machines. The table was tilted in their favor, bigtime. Much more than today.