Studies: High Frequency Trading Claims of Market Efficiency Not Valid

October 2nd, 2012
in econ_news, syndication

Econintersect:  High frequency trading (HFT), transactions that take place in milli-seconds (and even micro seconds), now account for more than broken-spring-with-manSMALLhalf of all the stock trades on U.S. exchanges.  Public concern for such recent events as the May 2010 Flash Crash, the out-of control trading software implementation that cost Knight Capital (NYSE:KCG) more than $400 million (and almost ended it's existence) in minutes earlier this year, the badly botched trade reporting that accompanied the Facebook IPO (NASDAQ:FB) and the withdrawal of the IPO for BATS (Bats Global Markets Inc) in March after the firm messed up Apple (NASDAQ:AAPL) trading with a stream of bad quotes.

Follow up:

A trade association which includes high frequency traders (the Futures Industry Association Principal Traders Group) made a statement in September regarding the Senate Banking committee hearing on HFT:

“As we work together to further improve market infrastructure,  we must also preserve the meaningful improvements in market quality that have occurred as markets have become more automated and competitive.  Today, trading costs are lower, markets are deeper and more liquid, and prices better reflect information about the value of stocks and commodities. Those
improvements benefit everyone who relies upon markets, including long-term and individual investors.

Here are three other recent stories that do not agree with the statement above:

  • Thomas Peterffy, who pioneered computer-based high-frequency trading said in an interview with NPR Planet Money that speed trading has gotten so fast that it now “has absolutely no social value” and "does more harm than good."
  • Bloomberg says that the "real benefits" come with costs:  "wild volatility" and "trading snafus."
  • Witnesses at the Senate Banking Committee hearin on HFT had critical views of HFT.

A Financial Times article by Vince Heaney has a summary of critical independent studies:

Computerised direct market access has dramatically reduced spreads compared with the days of purely phone-based dealing, but there is evidence that now that high frequency trading is on the rise, spreads are no longer tightening. A 2012 academic study by Watson, Van Ness and Van Ness found the average bid-ask spread for US equities from 2001-05 was 2.2 cents, but from 2006-10, which coincides with the rapid rise of HFT, the average spread was 2.7 cents, an increase of 23 per cent. During the latter period, the study also found a 24 per cent increase in stock volatility. Similarly, a 2010 Yale School of Management paper found HFT was positively correlated with stock price volatility and stock prices tended to overreact to fundamental news when high frequency trading was at a high volume.

Two other studies mentioned in the Financial Times article were:

  • An April 2012 study by Morgan Stanley which showed that institutional trades were moving market prices more this year than they had in the past.

From Bloomberg:

The Securities and Exchange Commission is holding a round table Oct. 2 to review what to do about high-frequency trading, but we aren’t optimistic. The gathering is little more than a fact-finding mission, and the agency hasn’t proposed significant fixes.

A big problem is that the data is not available for high speed transactions until long after they have transpired and many additional follow-on trades may have taken place.  Ordinary investors who deal with data streaming at fractions of a second are unable to know what the real market is  because a thousand trades may have occurred after the instant for which they see data and they have no knowledge of that.  An analogy would be to a trader in 1970 who had to place an order knowing only what the last trade was a week ago.  No wonder retail investor confidence in markets is at low ebb.

To try to start addressing some of the concerns, the SEC has announced plans to establish capability to analyze HTF activities.  Gregg Berman, who holds a doctorate in physics from Princeton University, will head the commission’s planned office of analytics and research.

Editor's note: Bradley Lewis and Nicholas Sankowski had a GEI Great Debate© on High Frequency Trading and Transaction Taxes in December 20111.

John Lounsbury


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