A new paper written by a group of European academics raises some serious concerns about the effects of high frequency trading. The paper titled “Rock Around The Clock: An Agent-Based Model of Low and High Frequency Trading” uses a very sophisticated agent-based model to simulate the interactions between high and low frequency trading. The model is one of the first of its kind to study how “high frequency traders, who hold event-based trading-activation rules, place orders according to observed market volumes that constantly exploit the information provided by LF traders.” In other words, the model studies how HFT picks off low frequency traders.
The authors make a very keen assumption about HFT: “we assume that the activation of HF agents depends on the extent of price fluctuations observed in the market.” In other words, HFT is not concerned about fundamental or technical analysis and all that matters are price changes. Here is how the authors describe the HF traders in their model:
“HF traders adopt directional strategies that try to profit from the anticipation of price movements. To do this, HF agents exploit the price and order information released by LF agents.”
Sure sounds like scalpers to us and not market makers (but that’s a topic for another day). Now let’s get to the results of the model simulation:
“Overall, our results validate the hypothesis that HFT exacerbates asset price volatility, generates flash crashes and periods of market illiquidity (as measured by large bid- ask spreads). At the same time, consistent with the recent academic and public debates about HFT, our findings highlight the complex effects of HF traders’ order cancellation on price dynamics.”
But wait a second, didn’t those HFT proponents tell us that flash crashes were caused by fat-finger human traders? Apparently, the authors of this paper didn’t get that memo and instead point the finger at HFT for the cause of flash crashes. They state:
“The emergence of flash crashes is strongly related to the presence of HF traders in the market.”
There is one bit of good news for HF traders in this paper. The authors say that the fast cancellation rates of HF traders actually lead to a quick recovery after a flash crash.
Now, we’re sure the folks at the Modern Markets Initiative and their allies at some of the stock exchanges will try to discredit this paper. They will probably say that it is just a simulation and not based on actual data. They will claim that there is still no evidence that HFT is harming the market. This couldn’t be further from the truth. The evidence is piling up now which is probably one of the main reasons why the HFT community hired two Washington DC insiders to help with their lobbying group. They know that the regulators will eventually catch on to their games and possibly implement some rules to put an end to them. We would recommend that the SEC reach out to the authors of this paper and ask for access to their model. Heck, maybe they can run some MIDAS data into the model and see what pops out.