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Crashes and High Frequency Trading

11

January, 2012

We have talked in the past about the UK Foresight Project and we have highlighted a few of their academic papers. It still puzzles us how the HFT community initially thought that the UK Foresight project exonerated them. Today, we would like to highlight another paper that was written for the project titled “Crashes and High Frequency Trading”  by D. Sornette and S. von der Becke. The authors lead with “Can high frequency trading lead to crashes? We believe it has in the past, and it can be expected to do so more and more in the future…As a consequence of the increasing inter-dependences between various financial instruments and asset classes, one can expect in the future more flash crashes involving additional markets and instruments.” We pretty much can stop right there but let’s highlight a few more other points that the authors make:

“An important point is that the focus on liquidity provision by HFT may be misguided. First, liquidity is not equal to volume.

- Trade volume, however, is not liquidity but all too often mistaken for it. Liquidity means “there is a bid/offer on the other side when I need it, for the amount I need it (market depth) at a reasonable level (market breadth).

Second, the hypothesis that HFT is a positive development is often based on the underlying assumption that more liquidity is necessarily good for investors and companies.

- the utility derived from liquidity provided by HFT could be argued to be lower than from other market participants. Why? Because HFT does not absorb risks.

- They carry no inventory; there is no transfer of risk apart for some milliseconds. HFT are opportunistic, they arbitrage what is referred to as “inefficiencies”, but may often result from differences in time scales and technology. It remains to be seen if liquidity is a real robust externality of the behaviour of HFT. “

In other words, the authors of this paper are not believing the “we add liquidity” argument that you hear so often from the HFT lobby. Lastly, we’d like to highlight this fact that the authors bring up:

A recent report showed that the frantic development of HFT has slowed down in developed markets, and there is a transfer of activity to emerging markets such as Russia, Brazil and Mexico where exchanges are beginning to revamp their systems to attract such players.”

As the opportunities for HFT dry up in stock markets that have been saturated, they will simply move on to new markets. This is evidenced by the declining volume in US equity markets. NYSE Euronext said the volume of trading in stocks it handles in the United States fell 10.6 percent in December. While they may be moving on to new markets, they have left a path of destruction in their wake. And as the authors of this paper claim, “financial instabilities can be expected to flourish in a world dominated by HFT”. In other words, the markets are now more susceptible to flash crashes thanks to HFT.

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