We came across a very interesting twenty one page article titled “Cracks In The Pipeline Part Two: High Frequency Trading” written by Wallace C. Turbeville  While much of the article has already been covered by other market structure participants, the article has a few unique viewpoints that we think are often overlooked.  Specifically, we find the authors comments on liquidity and price discovery process to be spot on.

On Liquidity:

“Another way to think about liquidity is that it provides stability of prices within the current spread between reliable purchase and sale price quotes. Predictability and stability are closely related.”

“Much of today’s historically high trading volume does not provide market liquidity when markets are under stress – that is to say at precisely the time that liquidity is most needed. The shift from providing liquidity to consuming it is unpredictable and, as a result, even more disruptive. And these shifts occur on a daily basis.”

On Price Discovery:

“In a well-functioning market, price levels reflect the fundamental value of securities and derivatives being traded based on currently available information that is relevant to fundamental value.  Even when the market is not stressed, commonly used high volume trading tactics drive market prices away from the fundamentally sound values that efficient markets achieve. As a result, the price levels discovered by market participants are distorted by market maneuvers and are unreflective of fundamental values, reducing market efficiency.”

“Chronic price distortions are not merely vehicles for clever traders to get the better of slower and weaker market participants. Distortions caused by illusory liquidity, aggressive trading tactics and non-transparent trading make the marketplace unreliable.”

On HFT:

“This type of volume does not provide useful liquidity. It is unreliable and can destabilize prices rather than providing predictability. Worse, Information Trader volume can appear to a market observer to be stabilizing, but converts instantaneously and unpredictably into a destabilizing force under stressed or unforeseen market conditions. This prospect hangs over a market creating underlying uncertainty that impacts prices even when markets are stable.”

“High-speed algorithmic information traders extract far more value than they add, burdening the Capital Intermediation process.”

While we often hear that HFT adds liquidity and has dampened volatility, the concepts of the unpredictability of liquidity and the distortion of the price discovery process in today’s market are often not talked about by proponents of HFT.   Can we trust that liquidity supplied by automated market makers will always be there?  Can we trust that the prices being set in the market are the result of all information currently available to obtain an accurate fundamental valuation?