HFT is here to stay says GreySpark report
Despite its negative public perception, high-frequency trading can act as a force for good in capital markets by adding efficiencies that help investors get a better deal – but only if it is properly regulated, according to new research by technology consultancy GreySpark Partners.
According to the GreySpark document, High-Frequency Trading: the Good, the Bad and the Ugly, HFT can increase liquidity, reduce market volatility and enhance price discovery. However, it also warns that HFT firms and venues where HFT is present are failing to safeguard their operations if they do not correctly implement the necessary risk management measures.
“Our research found overwhelmingly in favour of the need for the greater integration of circuit breakers in all high-frequency trading systems that can be used to complement thorough testing procedures for trading algorithms,” said Anna Pajor, senior consultant at GreySpark and author of the report. “We are advocating these risk management steps as examples of necessary risk measures. However, the most successful risk management strategy is the one that assumes a holistic approach.”
Single stock circuit breakers were introduced to the US market by regulator the Securities and Exchange Commission after the flash crash of 10 May 2010 in an attempt to prevent sudden bouts of extreme market volatility. Two years later, the SEC approved a system that limited price movements in all stocks to a price band decided by the stock’s average price over the previous five minutes.
Circuit breakers are intended to counter the possible extreme effects of computerised trading systems feeding on each other, such as the flash crash, when $1 trillion was wiped off the value of the US stock market within five minutes before suddenly rebounding. However, some observers have criticised circuit breakers on the grounds that stopping the market at the moment when it most needs to find price equilibrium may actually increase volatility when the market reopens, rather than reduce it.
According to GreySpark, the fundamental driver for the growing popularity of HFT systems among hedge funds and banks is a market environment that incentivises the provision of liquidity, at the same time as financial products are becoming more complex. The firm notes that exchanges will continue to court HFT due to the profits to be gained from colocation, although it concedes that regulators will continue to attempt to hamper the full development of market structures that favour HFT.
The traditional arguments in favour of HFT are that it improves liquidity by its continuous presence in the market, and that it narrows spreads by removing price inefficiencies. It has also been argued that HFT dampens volatility because HFTs are quick to trade against market extremes, thus providing valuable market correction.
The arguments against HFT are that it provides illusory liquidity over timespans that are too short for a human investor to interact with; that it preys on long-term institutional flows, hurting genuine investors and damaging the real economy; that it is short-term speculative activity that adds no real benefit to the market; that it promotes market manipulation and abusive trading strategies that undermine the stability of the market.
HFT was one of the top topics at the TradeTech conference in London earlier this month, where a heated discussion showed up sharp divides in opinion between supporters and detractors of the practice.