Why You Should Thank High Frequency Traders for Lower Volatility

New data from Credit Suisse highlights how high frequency trading activity contributes to lower volatility in the marketplace.

As reported by the Wall Street Journal, “Researchers at the Swiss bank’s New York offices posit that HFT activity has helped inoculate large-caps from the effects of macroeconomic market stresses.”

Featuring graphics from the Credit Suisse note, the Modern Markets Initiative has created the below infographic to showcase these findings:

These findings from Credit Suisse are the latest in a series of research showing the many benefits high frequency trading and professional traders provide to the marketplace and end investors. For more, please visit the MMI’s Research & Studies page.

Worstall: “High Frequency Trading Really Does Save Investors And Traders Money”

The state of our financial markets has been a popular subject of debate lately. Unfortunately, amidst discussions on how to strengthen existing market structure, a lack of clarity around high frequency trading’s beneficial impact on today’s markets persists.

In his most recent article for Forbes, Tim Worstall provides a welcomed fact-based explanation of how high frequency traders save investors and traders money in the marketplace. According to Worstall, the question shouldn’t be whether high frequency traders make more money than other traders, but rather, “whether the existence of HFT leads to investors spending less money overall on trading in the markets.”

The answer? “Very much so, yes” writes Worstall. To support his position, he points out analysis by Professor Craig Pirrong on data in a paper commissioned by the CFTC investigating how HFTs impact liquidity in the marketplace:

“Specifically, Table 1 has data on spreads in from the electronic NYMEX crude oil market in 2011, and from the floor NYMEX crude oil market in 2006. The mean and median spreads in the electronic market: .01 percent. Given a roughly $100 price, this corresponds to one tick ($.01) in the crude oil market. The mean and median spreads in the floor market: .35 percent and .25 percent, respectively.

“Think about that for a minute. Conservatively, spreads were 25 times higher in the floor market. Even adjusting for the fact that prices in 2011 were almost double than in 2006, we’re talking a 12-fold difference in absolute (rather than percentage) spreads. That is just huge.

That spread is, if you like to think of it this way, what any investor or trader is paying for the privilege of being able to make a trade (and we might add to that broker fees, taxes and so on.) Those spreads coming down by a factor of 25 has obviously saved such traders vast sums of money over the years. So HFT does save investors money.”

End investors are not incurring losses as a result of HFT, and in fact, have much to gain from the lowered costs and increased access resulting from competition between these professional traders. Those in the HFT industry are making money gains as well (although this does come with risk.) Worstall then poses the question: if these two groups are benefiting who is “losing”?  To find out, read Worstall’s full piece here.

 

When Improving Markets, First Do No Harm

John McPartland of the Chicago Fed has released a new policy discussion paper: Recommendations for Equitable Allocation of Trades in High Frequency Trading Environments. The paper makes “nine recommendations, that if implemented would likely restore the perception of fairness and balance.” John McPartland is knowledgeable and rational, so his recommendations should be taken seriously and debated by the industry. However, we must keep in mind that any resulting changes should be carefully considered, data-driven, and do no harm.

We must constantly strive to perfect our market, and we can certainly do better, however, today’s markets are not broken or rigged. The markets have never been better for end investors. Costs are low, spreads are tight, and liquidity is plentiful.

Investment managers will tell you that the current state of electronic markets, including high frequency trading, is beneficial to their customers – the end investors. Here are a few representative quotes:

BlackRock recently wrote: “[Electronic market making] brings tangible benefits to our clients through tighter spreads.”

Gus Sauter, who was Chief Investment Officer at Vanguard said: “Generally speaking, high-frequency traders provide liquidity and “knit” together our increasingly fragmented marketplace, resulting in tighter spreads that benefit all investors. We believe that a vast majority of “high-frequency trading” is legitimate and adds value to the marketplace.”

Cliff Asness of AQR Capital Management wrote: “How do we feel about high-frequency trading? We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars.”

Even Ronan Ryan, a protagonist of Flash Boys, had this to say about high-frequency trading: “They have made the markets far more efficient in that regard and it’s great for everybody, from brokers all the way down to the mom-and-pop shops. It’s fantastic.”

It is clear that the evolution of the electronic marketplace and the rise of high-frequency trading has greatly benefited investors. It is also clear that our markets are not perfect. Any and all changes to market structure must ensure that we do no harm and do not reverse the benefits we have gained from electronic trading over the last decade.

The market is well-served by SEC Chair, Mary Jo White who understands that changes must be made with caution. As she recently said:

“Addressing the issues of our current market structure demands a continuous and comprehensive review that integrates targeted enhancements with an expansive consideration of broader changes. But we must not ignore the largely positive evidence of market quality. That reality demands careful study and deliberate action when considering fundamental changes.”

The SEC, with its data-driven approach and recently announced pilot programs, is taking a step in the right direction. Any possible changes that arise from suggestions such as Mr. McPartland’s should continue down the same path: thoroughly discussed, backed by data, and only implemented if they truly improve the markets for investors.

– The MMI

MarketWatch: "Ban High-Frequency Trading? ‘Absolutely Not!’ Financial Execs Tell Senators"

At a hearing this week held by the Senate Banking Committee on electronic trading and equity market structure, top industry veterans were quick to point out that vilifying one style of trading will not help our markets. In fact, they said, removing it from the markets would be detrimental. Rather, we should examine our current market structure and make necessary changes.

As an article in MarketWatch notes:

“Ban high-frequency trading, anyone? No thanks.

“That was the response Tuesday from witnesses at a Senate Banking Committee hearing to a question from Nebraska Republican Sen. Mike Johanns. The committee held a hearing on electronic trading and market structure, and while controversial, high-frequency trading was defended by three executives and one academic with industry ties.

“’Absolutely not!;’ said Kenneth Griffin, founder and chief executive of Citadel LLC, a financial firm that engages in high-frequency trading, in response to Johann’s question. Kevin Cronin, global head of trading at asset manager Invesco Ltd., IVZ +0.82%  agreed, and also told senators high-frequency trading is “not bad” in and of itself. Jeffrey Sprecher, the CEO of Intercontinental Exchange Inc. ICE +0.04% , which owns the New York Stock Exchange and other markets, as well as Georgetown University Prof. James Angel, who sits on the board of DirectEdge, another stock-exchange operator, agreed the practice shouldn’t be banned.

“But while executives said they didn’t want to ban the trading practice, they did call for changes in market rules. Cronin, for example, called for requiring all high-frequency trading participants to register with regulators. That would give regulators access to records needed for investigations. Sprecher, meanwhile, said markets are too complex and that deters some investors from accessing the public markets.”

 Read the entire article on MarketWatch.com here.

Bart Chilton Commentary in NYT: “No Need to Demonize High-Frequency Trading”

The MMI wanted to make sure you have seen the latest commentary from Bart Chilton in the New York Times’ DealBook, entitled “No Need to Demonize High-Frequency Trading.”

According to Chilton, a former CFTC commissioner, “the real lesson of the recent attention to such [high-frequency] trading, is this: technology in modern markets is here, will not disappear and is providing significant benefits to institutional and retail investors.”

Like any other kind of market participants, we should keep our minds open to both the positives and negatives of high-frequency trading, argues Chilton: “For example, even though the New York attorney general’s complaint and the general public conversation use demonizing words like ‘predatory’ and ‘toxic’ to describe high-frequency trading, study after study has proved that modern markets are cheaper and safer than ever before.”

Supporting the efforts of SEC Chairwoman White to begin data-driven reviews of U.S. market structure, Chilton explains that while certain aspects of the HFT industry do need possible oversight, we must preserve the many benefits electronic trading has brought to end investors and the marketplace:

“We want the benefits of high-frequency traders and their technology, but we need to make sure the technology is being deployed safely and responsibly because everyone has a stake in the outcome.

“… Fortunately, there is an emerging view among some in the world of high-frequency trading that in addition to a fulsome discussion about the benefits of such trading, we should require more advanced regulation.”

Read Chilton’s entire commentary here.

The Technology Investor: "Indispensable" HFT Mitigates Risk

In a piece for Casey Research’s The Technology Investor, senior editor Doug Hornig zeroes in on some of Flash Boys author Michael Lewis’ most questionable claims about HFT. He also settles the score about HFT’s role in the flash crash of 2010, seeks to settle misplaced fears about HFT, the role it plays and whether or not the markets are “rigged.”

In discussing what actually causes major market disasters – and HFT’s true role – he writes:

Well, consider this: Market disasters generally result from risk that exceeds supportable levels. The collapse of ‘08 was triggered by the trading and re-trading of mortgage-backed securities that couldn’t be accurately valued. With each trade, the risk was magnified some more, until it finally overwhelmed the system. Or take the dot-com crash, which came about because the price of revenue-free startup companies was bid so high that the risk of continuing to hold them blew way past the probability of selling to the next sucker in line.

HFT, on the other hand, is about the exact opposite—mitigating risk.

And on the flash crash:

As a market stabilizer, proponents say, HFT has become indispensable. They point to the infamous Flash Crash of ‘10, which took the Dow down nearly 1,000 points in 20 minutes.

 The trigger for that was a simple human error. HFT quickly re-priced securities and stair-stepped them back up to their proper levels, it is argued, thereby reversing the crash before it could spin entirely out of control.

Hornig’s piece is a frank look at recent HFT criticisms combined with an easy-to-understand translation of what actually occurs in the markets. Through his piece he shows how HFT benefits investors, today’s modern markets and establishes that it is not something to fear.

Check out more of the best lines from his piece, “How I Learned to Stop Worrying and Love High-Frequency Trading” here.

Nabicht: “Professional Traders, HFT Technology and the Value Provided to Investors”

In a commentary for The Hill, Modern Markets Initiative (MMI) senior advisor Peter Nabicht explains how investments in automation technology have transformed the old, closed trading floor model into a marketplace that is more transparent and accessible than ever before for today’s average investor.

“As lawmakers continue to hold hearings on Capitol Hill,” writes Nabicht, “they should be aware that our financial markets have always had professional traders who worked as intermediaries, ensuring customers could find a good price when they needed to trade.”

According to Nabicht, thanks to advances in telecom and computer technology, “information about what orders were in the market was no longer limited to just the traders occupying the floor of the exchange. Now, anyone who invested in a data line and a computer could see all the details of what orders were in the market.”

Today’s modern markets are not perfect, acknowledges Nabicht, but “as we confront the challenges and opportunities that modern technologies offer to financial markets, we need to remember that the new market structures and high frequency trading have produced efficient markets that provide fair prices to investors.”

Read Peter Nabicht’s full commentary on TheHill.com here.

Actually, HFTs Take on a Lot of Risk

Jason Carroll of Hudson River Trading, a member of the Modern Markets Initiative (MMI), has framed out some thoughts explaining how professional high frequency trading firms do in fact take on and manage risk in today’s modern markets:

One of the frequent criticisms of HFT is that HFT firms don’t take any risk.  The most frequently cited example is Virtu’s statement that in 1,238 trading days it was profitable in all but one. I’d like to explain why this isn’t as preposterous as it sounds.

A traditional trader or market maker from a decade ago was not automated. He or she traded by walking into a pit or up to a trading post or possibly by clicking a key by hand as he sat at a NASDAQ Workstation waiting for someone to try to trade with him. Frequently he traded a few products or symbols. The number of trades he made in a day probably measured in the range of 10-100, and his success rate on those trades was probably 60-70%.

He probably worked for a firm that, in aggregate, employed dozens to hundreds of traders covering a broader array of products.  In addition to covering many more products, these traders also probably covered an array of trading ideas — from shorter-term market making activity to longer-term inter-product arbitrage strategies.  Any individual trader’s daily Profit or Loss (“PNL”) was probably far more volatile than the firm’s aggregate PNL, because when you sum diverse and independent sources of PNL, you end up with a smoother aggregate total.

Many automated trading firms (or HFTs) conduct very similar activity, except they do more of it, for smaller rewards, using computers. An HFT firm may manage to trade 100s to 1000s of times a day in 1000s of products and symbols in different asset classes and markets around the world. Our success rate is closer to 51-52% than 60-70%, and the amount we stand to make or lose in any single trade is also smaller than what a manual trader faced.

Consider these two contrived companies:

Firm 1 employs 10 human traders, and each human trades 10 times a day.  Each trader is right 60% of the time, and each trade makes or loses $500.  Given that data, Firm 1 will trade on average 100 times a day, and make $10,000 per day.

Firm 2 employs 10 people who develop automated trading strategies, and each employee is responsible for 10,000 trades a day made by those strategies.  The strategies are right only 50.5% of the time, and they stand to make or lose $10 per trade.  Firm 2 will trade on average 100,000 times a day, but will still only make $10,000 per day.

For an individual human trader described at Firm 1 to lose money, he’d have to be wrong in more trades he was right. So he’d have to be wrong in 6 trades and right in 4 trades.  Statistics tells us the chance of losing at least 6 trades out of 10 when your win percentage is 60% is only 16%. So about 1 in every 6 days, each human trader will lose money.

Here’s a calculator that you can use to check my math: http://stattrek.com/online-calculator/binomial.aspx.  For a deeper explanation of the statistics behind the math, I’d recommend reading some of the links on that page.¹

For Firm 1 overall to lose money on a given day, it would have to be wrong in at least 51 trades.  The chance of losing in 51 trades out of 100 when you’re right 60% of the time is even lower than 16% — it’s 1.7%.  That means Firm 1 will lose money about 1 in every 60 days, or about 4 losing days a year assuming the firm doesn’t trade on weekends and holidays.

For Firm 2 to lose money on a given day, it would have to be wrong in at least 50,001 trades.  The chance of being wrong in 50,001 trades or more out of 100,000 trades, when you expect to be right 50.5% of the time, is very, very small — it’s .077% or approximately 1 in 1292.  So that means that this firm will lose money in one day every 5 years.

Is Firm 2 taking risk?  On any given trade it’s taking on a lot of risk.  It has a far smaller chance of success on each trade than the human traders do.  But because Firm 2 makes so many trades, it achieves a much more stable PNL profile than the human trader.

In general, investors should appreciate that automation has allowed firms to compete more aggressively to participate as market intermediaries. After all, the better such firms are able to manage risk, the smaller the reward is they need to capture in order to viably provide short-term liquidity.

Footnotes:

[1] For the stats geeks among you, I acknowledge that this analysis relies on the assumption that the outcome of all of the trades is determined independently.  That’s probably not the case either at Firm 1 or Firm 2.  Weakening that assumption may change the scale of the comparison, the effect I demonstrate from making a much larger # of trades still exists.

For more information on this topic, please also read a previous post from the MMI entitled “No Trading is Without Risk.”

– MMI

FACT CHECK: "Average Joe" Investors and the Benefits of HFT

A recent commentary piece in The Guardian about the “Average Joe” investor contained a number of inaccuracies regarding high frequency trading and electronic markets.

MMI senior advisor Peter Nabicht reviewed the commentary and set the facts straight, giving the piece “the Walmart treatment“:

 

The Modern Markets Initiative has many resources available to members of the media, regulators, lawmakers and end investors who want to learn more about our electronic markets. Please visit our Investor Benefits page and watch our “What is High Frequency Trading?” video to learn more.

 

Mark Spanbroek: “Squeezing the Middlemen”

Following the release of Michael Lewis’ book Flash Boys, the role of “middlemen” in the marketplace has come under scrutiny.

The fact is, our financial markets have always had “middlemen” coordinating trades between market participants. Even 20 years ago, these middlemen were part of an exclusive group of floor traders that closed off access to average investors. However, thanks to investments in technology and high frequency trading practices, in recent years middleman have reduced transactions costs and improved access more than ever before for the average investor.

As FIA EPTA Vice-Chairman Mark Spanbroek explains in a new blog post, middlemen provide an extremely valuable role in today’s market structure, especially for end investors, much like other industries:

“While it is true to say that technology, particularly the internet and digital communication, has radically reshaped the way we all do business (not just in the financial markets), it would be wrong to say that middlemen are no longer needed. Certainly there are fewer middlemen, supply chains have been simplified, and the number of links between the two ends of a purchasing chain have shrunk, to the great benefit of all those concerned at the ends of the chain; yet very rarely can we do away with the middleman completely.

…

“Similarly, whereas once we had to go to a travel agent to be able to book a holiday, now we can simply go online, looking for the best possible deals for our flights, hotel, car hire etc. There are far more competitors for this business, with individual and aggregated / comparison sites (middlemen), as well as the ability to book directly from the airline or hotel (no middlemen at all), cutting out the need to pay travel agent’s fees. The travel agent still exists, but more and more of their business is to provide a combined version of these services online, or to provide a custom-made holiday plan for a more comprehensive package. 

“The internet has reduced the cost of many day-to-day consumer purchases, by replacing middlemen with cheaper alternatives (often due to greater competition) and in some cases removed them completely, bringing customers into contact with the manufacturer. And while this has changed the way we do business, accepting the new technology as part of our everyday lives brings a lot of benefits and keeps us primed for future innovation.”

Spanbroek rightfully argues that “the rise of algorithmic trading has cut out a lot of middlemen in the markets” thereby “enabling more participants to connect directly to the exchange.” Investors have also benefited from the competition between traders utilizing algorithmic trading strategies, since “those who remain have had to find new, more cost-effective ways to provide their service.”

The advancements in technology in today’s modern markets should be embraced by all market participants and preserved to keep costs low for end investors. Read Spanbroek’s entire blog on FIA EPTA’s website here.