Are High Frequency Traders About to Destroy the City of London?
My attention has recently been drawn to an academic research paper entitled High Frequency Trading and The New-Market Makers. The author, who is from the VU University in Amsterdam, investigates the connection between high frequency trading and the emergence of new exchanges here in Europe:
It shows how the success of a new market, Chi-X, critically depended on the participation of a large HFT who acts as a modern market-maker. The HFT, in turn, benefits from low fees in the entrant market, but also uses the incumbent market Euronext to offload nonzero positions.
To summarise the findings:
One particular set of broker IDs matched across markets shows the characteristics of an HFT that acts as a market maker in both the entrant market (Chi-X) and the incumbent market (Euronext). In each market, four out of five of its trades are passive, i.e., the HFT was the (liquidity-supplying) limit order in the book that got executed. It makes money on the spread but loses money on its positions. If this positioning loss is decomposed according to duration, one finds that positions that last less than five seconds generate a profit whereas the ones that last longer generally lose money. The HFT is equally active in both markets as roughly half of its trades are on Chi-X and the other half are on Euronext.
The paper shows how fees are a substantial part of a high-frequency trader’s profit and loss account. It is therefore not surprising that new, low-fee venues have entered the exchange market as they are attractive to these ‘modern’ market makers. It is shown that such lower fees are, at least partially, passed on to endusers through lower bid-ask spreads. This evidence adds to the regulatory debate on high-frequency traders and highlights that a subset is closely linked to the rapidly evolving market structure that is characterized by the entry of many new and successful trading venues.
This research seems to suggest that high frequency trading is actually a good thing, both for the "New-Market makers" themselves and the beneficiaries of the resulting lower bid-ask spreads on new exchanges such as Chi-X.
However this view doesn't seem to be held by regulators on both sides of the Atlantic, since as we discussed back in 2009, both SEC chairman Mary Schapiro and the then UK "City minister" Lord Myners held the view that:
We need a deeper understanding of the strategies and activities of high frequency traders and the potential impact on our markets and investors of so many transactions occurring so quickly. And we need to consider whether there are additional legislative authorities needed to address new types of market professionals whose activities may not be sufficiently regulated.
It seems as though the US legislative authorities have been as good as their word, since one of the references at the back of HFT & The New-Market Makers is another academic paper. This one is entitled "The Flash Crash: The Impact of High Frequency Trading on an Electronic Market", and the authors hail from another US regulator. In this case it's the CFTC. They conclude:
Based on our analysis, we believe that High Frequency Traders exhibit trading patterns inconsistent with the traditional definition of market making. Specifically, High Frequency Traders aggressively trade in the direction of price changes. This activity comprises a large percentage of total trading volume, but does not result in a significant accumulation of inventory. As a result, whether under normal market conditions or during periods of high volatility, High Frequency Traders are not willing to accumulate large positions or absorb large losses. Moreover, their contribution to higher trading volumes may be mistaken for liquidity by Fundamental Traders.
We conclude that HFTs did not trigger the Flash Crash, but their responses to the unusually large selling pressure on that day exacerbated market volatility.
Not exactly the same conclusion as the Dutch paper then, and not exactly a clean bill of health either. However exacerbating market volatility isn't quite the same thing as destroying Western capitalism as we know it.
Not content with leaving these matters to the Anglo Saxons, it seems Angela Merkel and Nicolas Sarkozy have been discussing similar issues recently. According to the Daily Telegraph Mr Sarkozy said:
The French and German ministers will table a joint proposal at EU level next September for a tax on financial transactions. This is a priority for us.
This so called "Tobin Tax" has been previously mooted as one way of making high-frequency trading unprofitable, and thereby ridding the world of its menace once and for all. According to the Telegraph once more:
The plans by Germany and France to introduce a financial transaction tax (FTT) could raise a total €80.9bn (£70.7bn) – of which €58.3bn would come from UK-based businesses.
As you may be able to imagine, this Continental concept hasn't gone down too well with some of the aforementioned UK-based businesses. In particular Michael Spencer, founder and CEO of ICAP and last year's Ernst & Young World Entrepreneur Of The Year, seems to have taken a very dim view of it. According to Mr. Spencer:
This tax would destroy the City and cost the Exchequer billions, but it would benefit Brussels. Companies like ICAP will simply move elsewhere outside the EU if Nicolas Sarkozy and Angela Merkel push ahead with this silly tax.
Unlike their Labour predecessors, it seems as though the current Tory government isn't wild about the plan either:
Last week, Treasury sources signalled that Britain would be prepared to veto such a tax if Paris and Berlin succeed in bringing the plan to a vote among 27 EU members.
I'm sure that Mr. Spencer's donations to the Tory party have no bearing on any of that, but all these conflicting signals are nonetheless terribly confusing. If you're currently an Anglo Saxon high frequency trader now would seem like a prudent time to consider plan B, if you haven't done so already.
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