“I used to ask my boss many, many times: remind me what we do? And he would just go like: “we provide liquidity, we provide liquidity”. OK.  –  HFT Trader 

If you ask most HFT defenders what is the main benefit of high frequency trading, they will usually say that they provide liquidity.  But what does that even mean?  Do they provide a two sided quote of 100 shares per side that is a nickel away from the NBBO?  Do they quote on the inside market for most of the day? Do they make more than they take?

The liquidity issue has been the subject of many academic papers over the years but often these papers have relied on stale and incomplete datasets to reach their conclusions.  However, a paper titled “High Frequency Trading in the Bund Futures Market” has just been published by Germany’s central bank, the Deutsche Bundesbank, and uses a new and very detailed dataset to answer the liquidity question.   The dataset is unique for three reasons: (1) it uses microsecond data (2) a unique HFT flag, assigned by the Deutsche Borse, makes it possible to distinguish between HFT and non-HFT trading behavior (3) the data is from 2013 to 2014 which is much more recent than most other academic studies that we have seen.

The paper is also unique because rather than relying on trading volume data to study liquidity, the paper focuses on order deletion activity which can directly be related to volatility.  Here are some of the conclusions:

– “Active HFTs tend to follow momentum strategies, implying that they trade in the direction of the market return, which can increase intraday price movements. In contrast, passive HFTs appear to dampen excessive volatility using contrarian trading strategies.”

– “Active HFTs benefit from their speed advantage and trade in the direction of the news release within the first second after publication and thereby pick off the standing limit orders of NHFTs (non-HFT’s).”

– “HFT contributes more to noise than to permanent price volatility, which is in line with an overshooting behavior. This is a new finding in the empirical literature and implies that the trading by active HFTs adds significantly to price discovery but also generates disproportionally high short-term volatility through their fast and aggressive trading in response to macroeconomic news.”

– “Hence, the finding that under increased market stress, HFTs reduce their liquidity supply and consume more liquidity at the same time suggests that, overall, HFT trading exacerbates extreme price movements in those periods. This may in turn increase the risk of flash events that have been observed more frequently in the recent past, particularly in fixed income markets.”

– “Passive HFTs tend to delete more orders than they submit after market volatility has risen suddenly, since they fear higher risks to their market making activity.”

– “Overall a significant part of the liquidity supplied by HFTs disappears quickly as soon as market uncertainty rises, either expected or unexpected.”

These conclusions sure don’t sound like HFT provides liquidity.  Rather, it sounds more like they provide volatility.  The paper does segregate different types of HFT’s: Active (momentum based) and Passive (market making).  While most people believe there are good (market making) and bad (momentum) HFT’s, this paper shows that both types of HFT’s contribute to volatility in different ways.  Active HFT’s race ahead and pick off stale orders when volatility rises while passive HFT’s will often delete their orders as volatility rises.  Neither one of these activities contributes to liquidity.

The Bundesbank paper concludes with a plea to regulators to find a way to enhance liquidity:

“Therefore, regulators should think of potential measures to incentivize HFTs to generate more informational trades…Hence, finding ways to guarantee liquidity provision even during stress episodes is of particular importance.”

Unfortunately, since HFT’s are proprietary traders who only care about their own bottom line, we think the Bundesbank pleas will fall on deaf ears.