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The Winds Of Change

25

April, 2012

Do you feel it? Do you feel the winds of change blowing through the equity market structure debate? We are seeing more and more studies that have been questioning the so called “add liquidity/shrink spreads” HFT argument lately. And yesterday, there was a must read report released by Finance Watch ( a Brussels-based group) titled “Investing Not Betting”

The paper called on the EU to maintain a tough stance on HFT, dark pool trading, commodity derivative speculation and investor employee protection. We encourage you to read the entire paper but for the purposes of this note we are going to focus on what the paper said about HFT and dark pool trading. Here are a few of their points:

On liquidity vs volume:

Contrary to genuine liquidity, volume does not necessarily contribute to price formation or to the stability of financial markets. Liquidity and volume are not only different concepts but they also often contradict each other as, for instance, volume generated by aggressive speculative behaviour takes away liquidity from other market participants.”

On HFT market making:

True market making activity is about providing quotes to other market participants and not about taking existing quotes. We can see that the liquidity maker/taker fee model creates a situation where a so-called liquidity making activity which effectively provides very little, if any liquidity, subsidises an aggressive liquidity taking activity that, by definition, withdraws liquidity from the market.”

On tight spreads and providing liquidity:

The argument, so often put forward by the HFT industry, of the necessity to have short latency times in order to quote tight spreads proves that HFT does not provide liquidity: if speed is a prerequisite for tight spreads, then the prices quoted are not real prices as the possibility to withdraw quotes without trading becomes a condition for HF traders for quoting prices…posting firm quotes is a necessary condition of true liquidity provision: without a firm quote obligation, there can be no such thing as liquidity provision.”

On HFT arbitrage:

Although technically correct, the assertion that HFT corrects market inefficiencies needs to be put into perspective with two factors. First, by abandoning the concentration rule, MiFID 1 created mechanical price discrepancies between trading venues and therefore created arbitrage possibilities that did not exist before (which, in turn, helped the HFT industry to develop as those price discrepancies created large profit opportunities).”

On Dark Pool trading:

If an important driver for trading in the dark is a loss of confidence caused partly by HF traders, the first step should be to regulate HFT appropriately. Because, by definition, transactions executed in dark pools do not contribute to the price formation mechanism, regulators should ensure that waivers to pre-trade transparency are limited to the minimum and legitimate. Essentially, dark trading should be restricted to large orders , whatever the waiver used.”

Of course, as soon as the Finance Watch paper hit the wire, the FIA Principal Traders Group (aka the HFT lobby) came out and tried to attack it. They had their usual comments about lack of empirical evidence (also known as paid for academic studies) and that HFT lowers transaction costs. But what the HFT lobby fails to realize is that the public knows there is something wrong with the markets. The public knows the HFT lobby is just trying to protect their enormous cash generating machine. And the public is demanding change

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