Monday, March 31, 2014

How High Frequency Trading Helps Markets Become More Efficent

Bloomberg's Matt Levine has a very good backgrounder on how high frequency trading actually results in tighter spreads between bid and ask prices. Note: This has nothing to do with the contention of Tim Worstall at Forbes that HFT adds to liquidity. It doesn't, but it will cause spreads to narrow.

Here's Levine (Note: I think this explains part of what is going on with HFT, but not all. In some cases, it is pure and simple front running--not by seeing the market, but by seeing the trades in advance.)
While I wait for [ Flash Boys: A Wall Street Revolt] to arrive, though, let me spin for you an alternative Michael Lewis story. This one starts with a bunch of stodgy old banks filled with the sorts of equity traders whom you might recognize from Liar's Poker. "Liar's Poker" has nothing nice to say about equity traders at big banks. In this story equities, in Dallas or otherwise, isnot an intellectual power center.
But it's a simple operation. A trader quotes a stock, Microsoft say, bidding to buy it at $39.95 and offering to sell it for $40.00.3 If a big seller hits the bid, the trader owns a bunch of Microsoft stock at $39.95, and then tries to resell it at a profit.4 He does this using his gut instinct: If there's a big seller, that means the price should move down, so the trader might lower his quote to $39.93 bid, $39.98 offered, hoping to sell at $39.98 and make some profit. If the seller isreally big and really informed, the trader might move his quote down faster, because you don't want to be on the other side of the market from a big informed seller. On the other hand, if the seller is a small retail order, the trader might not move his quote at all: Uninformed small orders are basically random, so for every one of those who sells to you at $39.95, another will buy from you at $40.00, making you a big profit.5
If the trader's instinct is good, he'll make his spread trading with a lot of uninformed orders. If he's less good, or unlucky, he'll get picked off: He'll buy from big smart institutions at $39.95 when the "right" price is $39.90, and he'll end up with a big loss. Overall, though, it's a lucrative business, because the spread is wide enough to make up for the times that the trader loses.
Then along come some smart young whippersnappers who replace gut instinct with statistical analysis. Instead of relying on some equity trader's ample gut to guess what orders are likely to move the market, you can use a computer to figure it out, and then automate how you trade. If you build your computer right, you won't be blindsided by informed orders that go against you, like a lot of mortgage-backed securities traders were.6
And this means that you can quote a much tighter spread: By being smarter than the competition, you can also be leaner and more efficient. You might quote Microsoft at $39.97 bid and $39.98 offered on every exchange, knowing that as soon as someone hits your bid on one exchange, you can instantly move your market down to $39.96/$39.97 everywhere else. This reduces your risk of being picked off by trading with informed traders, which lets you make a profit even on much narrower spreads. You can charge less to trade by being more informed.
There are two ways of characterizing high frequency trading. In one, HFTs are front-running big investors, rigging the game against them and making the stock market illusory. In the other, HFTs are reacting instantly to demand, avoiding being picked off by informed investors and making the stock market more efficient.7
In my alternative Michael Lewis story, the smart young whippersnappers build high-frequency trading firms that undercut big banks' gut-instinct-driven market making with tighter spreads and cheaper trading costs. Big HFTs like Knight/Getco and Virtu trade vast volumes of stock while still taking in much less money than the traditional market makers: $688 million and $623 million in 2013 market-making revenue, respectively, for Knight and Virtu, versus $2.6 billion in equities revenue for Goldman Sachs and $4.8 billion forJ.P. Morgan. Even RBC made 594 million Canadian dollars trading equities last year. The high-frequency traders make money more consistently than the old-school traders, but they also make less of it.


  1. So you want to buy a stock for $5 and you wind up paying $10 and this is a good thing in libertyland where regulation can't possibly improve the world in any way.

    1. Re: Jerry Wolfgang,

      -- So you want to buy a stock for $5 and you wind up paying $10 --

      Where in the world are people paying double for what was quoted in the first place? I have seen you showcase your immaturity and ignorance of economics, but this takes the cake, JW,

      -- and this is a good thing in libertyland where regulation can't possibly improve the world in any way. --

      Regulation does not improve the world in any way precisely because regulations attempt to fix problems that do not exist, case in point: Your 100% spread fantasy, bred from ignorance of how trading happens or works.

    2. Oh man Jerry, you're right, the stock market isn't regulated enough. If only the government would finally regulate financial markets. I wish they would. May then all we wacky liberty lovers out here in liberty land would understand how great life can be when the benevolent minds of government save us from the financial executives. Maybe somebody will finally be able to protect us from evil predators like Tim Geithner over at Warburg Pincus!

    3. So if you aren't for "libertyland" Jerry, what are you for? Tyrannyland?

  2. Garbage.
    Presumably we should praise Willie Sutton for improving Banks' security!

    From a recent Bloomberg article

    Last week [early March, 2014] a large high-frequency trading shop disclosed that it made money on every trading day over the course of four years. Out of 1,238 trading days, they made a profit on 1,237 of those days.

    No human, nor any computer acting in the real-world market place, can have a record such as above, unless profit generation is based on front-running orders. Or, essentially stealing from other traders, whether individuals, funds, etc. One can only image what weird set of circumstances resulted in that single losing day. This practice should result in criminal action, not generate praise. Yes, I know the laws at this point do not make it a crime.