HFT Study Pulls Back the Veil and the Bride is Ugly

Econintersect: A report still in draft form written by two professors and a CFTC (Commodity Futures Trading Commission) economist presents detailed analysis of trading data by high-frequency trading  (HFT) firms.  The report details the study of the market by examination of specific trades.  One conclusion is that because HFT that reduces market liquidity (classified as “aggressive trading”) is more profitable than HFT which increases liquidity (classified as “passive trading”).  Econintersect estimates from the data presented in the report that the ratio of profitablity for aggressive trades vs. passive trades may be as high as 4:1.

The following graph from the report indicates that the liquidity withdrawing HFT activity (HFTa) is significantly larger than the activity that increases liquidity (HFTp).  From the report:

Aggressive HFTs (if >60% of their trades are liquidity taking), Mixed (if between 20% and 60% of their trades are liquidity taking), and Passive (if <20% of their trades are liquidity taking).

This is a condemnation of the claim that HFT activities provide liquidity to markets and therefore benefit traditional investors who can make trades more easily.  The HFT firms are taking money from the market and, on net, decreasing liquidity.  This is akin to paying the local mob to protect your store while they are actually doing the shoplifting.

The three researchers are Matthew Baron, Princeton University; Jonathan Brogaard, Foster School of Business, University of Washington; and Andrei Kirilenko, CFTC economist.

Here is the abstract of the current draft (November 2012) of the report of the study:

Abstract: We examine the profitability of high frequency traders (HFTs). Using transaction level data with user identifications, we find that high frequency trading (HFT) is highly profitable: HFTs collectively earn over $23 million in trading profits in the E-mini S&P 500 futures contract during the month of August 2010. The profits of HFTs are mainly derived from Opportunistic traders, but also from Fundamental (institutional) traders, Small (retail) traders, and Non-HFT Market Makers. While HFTs bear some risk, they generate unusually high average Sharpe ratios with a median of 4.5 across firms in August 2010. Finally, HFTs profits are persistent, new entrants have a higher propensity to underperform and exit, and the fastest firms (in absolute and in relative terms) earn the highest profits.

While the study determined that HFT was profitable, it is not a wide-open field.  In October a two year old HFT firm Eladian Partners shut down because of lack of business.  The ever declining trading volume for U.S. stocks has apparently sufficiently reduced the number of traditional investors needed to support the skimming operations of HFT.  When the flock diminishes the shearing productivity goes down and the number of shearers who can make a living is reduced.   From the New York Times:

The brokerage firm Rosenblatt Securities estimated that the profits these firms were expected to earn this year from trading American stocks would be down 35 percent from last year and 74 percent from 2009, at the industry’s peak.

The experience of Eladian Partners reflects on the observation (emphasis below) by Baron, Brogaard and Kirilenko in the introduction to their report:

In this paper, we examine the link between HFT speed, liquidity provision, and trading profits. We have four main findings. First, HFTs are profitable, especially Aggressive (liquidity-taking) HFTs, and generate high Sharpe ratios. Second, HFTs generate their profits from all other market participants, and do so mainly in the short and medium run (seconds to minutes). Third, firm concentration in the HFT industry is not decreasing over time, nor is its profitability. We conjecture this is tied to our fourth finding that HFTs profits are persistent, new entrants have a higher propensity to underperform and exit, and the fastest firms (in absolute and in relative terms) make up the upper tail of performance.

John Lounsbury

Sources:

• 
  The Trading Profits of High-Frequency Traders (Matthew Baron, Jonathan Brogaard and Andrei Kirilenko, Draft paper, November 2012)
  

• 
  HFT Critics Call CFTC Economist’s Study “Groundbreaking” (Melanie Rodier, Wall Street & Technology, 05 December 2012)
  

• 
  High Speed Traders Grab Significant Profits Away From Traditional Investors, Study Finds (Melanie Rodier, Wall Street & Technology, 04 December 2012)
  

• 
  Eladian Closure an Ominous Sign for High-Frequency Trading (Ivy Schmerken, Advanced Trading, 17 October 2012)
  

• 
  High Speed Trading Executives Shut Firm (Nathaniel Popper, New York Times, 16 October 2012)