European Regulators Summarize The Drivers and Risks of HFT
Nothing like a rising stock market to take high frequency trading out of the headlines. We here at Themis Trading however continue to monitor the HFT’s and continue to find new research papers from around the globe that question the so called benefits of HFT. We tend to look skeptically on many academic studies since many of the authors have a vested interest in supporting certain parties. We do find, however, that the European regulatory authorities have been asking more questions and attacking the standard HFT “add liquidity and tightens spreads” arguments. The European Securities and Markets Authority recently published a position paper on HFT that attacks the issue Read ESMA paper here They attempted to define HFT, outline the main drivers for its rise, identify its risks and then offer a few proposals on how to regulate it.
The ESMA definition of HFT is one of the better definitions that we have seen:
“A specific type of automated or algorithmic trading is known as high frequency trading (HFT). HFT is typically not a strategy in itself but corresponds to trading activities that employ sophisticated, algorithmic technologies to interpret signals from the market and, in response, implement trading strategies that generally involve the high frequency generation of orders and a low latency transmission of these orders to the market. Trading strategies of HFT can be non-directional (quasi market-making and arbitrage) and directional (mean-reverting, trend-following). They usually involve the execution of trades on own account (rather than for a client) and positions usually being closed out at the end of the day.”
They outline the main drivers which have contributed to the rise of HFT:
1) Technological progress and reduction of IT costs
2) Fragmentation of trading venues. ESMA says this is the strongest driver behind the rise of HFT and we agree. Excessive fragmentation creates sub second arbitrage opportunities that would not exist if there were not multiple venues trading the same security. Of course, competition is good but 13 exchanges and over 40 dark pools trading the same security seems a bit excessive.
3) HFT firms do not need as high a level of capital
4) Aggressive market center pricing (the maker/taker model)
5) Decrease in tick sizes (thank you Arthur Levitt for decimalization)
6) Colocation services
ESMA also outlines the risks of HFT:
1) HFT may increase volatility in times of market stress.
2) HFT may also lead to a form of “privatisation” of retail flow which could be analyzed as a form of front running.
3) HFT can result in significant intraday risks.
4) HFT may pose a risk to the stability of the markets in times of market stress.
5) HFT may enable the implementation of fraudulent strategies such as quote stuffing.
6) HFT has created a very major problem of surveillance of the market by the regulators.
The ESMA paper is a concise, up to date summary of why HFT is dangerous. Instead of the pundits just blindly ranting against HFT, maybe they should just quote from this ESMA paper.