I must admit my view of HFT has ranged from ambivalence – its simply technology moving on to mild annoyance at what looks like a sophisticated of front running that brokers have been practising since time began.
To try and get a better handle on what the impact of HFT is I revisted this transcript of a speech by Andrew Haldane of the Bank of England This serves as an interesting briefing paper on not only HFT but how technology has influenced trading over the past century.
For example –
at the end of the Second World War, the average US share was held by the average investor for around four years. By the start of this century, that had fallen to around eight months. And by 2008, it had fallen to around two months.
HFT has made its appearance at a time when there has been shift in the holding time of stocks – there had been a natural downward progression in holding times before the advent of HFT. Holding time as a sociological phenomena had already been changing, HFT seems to be the very pointy end of this change.
The thing I find interesting about the evolution of HFT is that it seemed to suddenly become available Whilst we had downward drift in the holding time of stocks we also experienced courtesy of technology a precipitous fall in transaction times.
As recently as a few years ago, trade execution times reached “blink speed” – as fast as the blink of an eye. At the time that seemed eye-watering, at around 300-400 milli-seconds or less than a third of a second. But more recently the speed limit has shifted from milli-seconds to micro-seconds – millionths of a second. Several trading platforms now offer trade execution measured in micro-seconds (Table 1).
As of today, the lower limit for trade execution appears to be around 10 micro-seconds. This means it would in principle be possible to execute around 40,000 back-to-back trades in the blink of an eye. If supermarkets ran HFT programmes, the average household could complete its shopping for a lifetime in under a second.
It is clear from these trends that trading technologists are involved in an arms race. And it is far from over. The new trading frontier is nano-seconds – billionths of a second. And the twinkle in technologists’(unblinking) eye is pico-seconds – trillionths of a second. HFT firms talk of a “race to zero”.
It is this mind boggling speed that enables HFT firms to make more than 80 million trades per day. To put the above quote into context the dreamed of transaction time of a pico second would be 0.000000000001 of a second which must be at the physical limit of our current computing technology.
In terms of the positives of HFT much is said about the impact they have had on the bid/ask spread and by extension market liquidity. The bid ask spread is in some ways a measure of liquidity. For example a very liquid instrument such as EUR/USD pair has a very low bid/ask spread because of its extreme liquidity whereas a small mining stock may have a large spread because of its perceived lack of liquidity. This paper quotes several studies that show that HFT has brought down the size of this spread thereby making trading cheaper. The best example he gives of this is the chart below which looks at the bid/ask spread on UK equities. This data has been massaged a little to remove volatility spikes.
However, despite this I am left with the unease of the flash crash where the supposed dark pools of liquidity provided by HFT simply evaporated leaving enormous holes in the market. It is this alignment of trading models that causes me unease – it is as if they all switch off at the same time. This indicates to me that they have either suffered convergent evolution and are based upon the same signals or that the models feedback on one another exacerbating any bump in the market or a combination of the two.
Haldane seems to come to a similar conclusion.
Far from solving the liquidity problem in situations of stress, HFT firms appear to have added to it. And far from mitigating market stress, HFT appears to have amplified it. HFT liquidity, evident in sharply lower peacetime bid-ask spreads, may be illusory. In wartime, it disappears. This disappearing act, and the resulting liquidity void, is widely believed to have amplified the price discontinuities evident during the Flash Crash. HFT liquidity proved fickle under stress, as flood turned to drought.
My take home message is that HFT is best described Henry Wadsworth Longfellow
There was a little girl, who had a little curl
Right in the middle of her forehead,
And when she was good, she was very, very good,
But when she was bad she was horrid.