This is the question asked by Evangelos Benos, from the Bank of England’s Financial Markets Infrastructure Division, on the Bank’s staff blog (Bank Underground). As well as providing a useful summary of the evolution of HFT, the main focus of the blog is a discussion of the overall impact of HFT on market quality. His conclusion? That while there are “some aspects of HFT activity that are still contentious… the inescapable conclusion that so far emerges is that HFT has mostly had a positive impact on market functioning.”
Benos focuses on the two main measures of market quality: price efficiency and market liquidity. The argument for price efficiency is very simple: those using high speed technology are able to receive and process information faster than the average participant (who has not invested in the same technology). Using this technology allows firms to process a larger volume of information than their counterparties, and more quickly, meaning these firms tend to have more reliable models for predicting future movements of the markets. The important point is that while this practice enables firms to make money, it also improves the price efficiency for the market as a whole. As Benos puts it: “to the extent that HFTs do make money, their trades are informed which also helps prices become more aligned with economic fundamentals“. It’s better for the markets if prices are informed by economic models based on real world information: the faster this is updated, the more efficient the prices are.
On the question of high frequency trading and liquidity, Benos supports the view taken by most of the market, including the big buyside funds:
“The evidence also suggests that (market-making) HFTs have contributed to improved market liquidity, as measured by the quoted prices at which one can trade (the bid-ask spread). This has happened for two reasons. First, being automated, market-making HFTs have lower operating costs which render them more competitive than traditional market-makers and can thus afford to quote a tighter spread. Second, they can cancel and withdraw quotes faster than traditional market-makers. This implies that, when the market moves, these quotes are less likely to be stale and to be executed at a disadvantageous for the HFT price [sic]. In other words, HFTs are less likely to be adversely selected. This limits their potential losses, allowing them to quote yet tighter spreads.”
It is very encouraging to see that as scrutiny of high frequency trading has intensified, both policy making institutions (such as the Bank of England) and regulators are coming to the same conclusions regarding the benefits that high frequency trading technology can have for the market. The Australian markets regulator, ASIC, released a report at the end of October on the state of high frequency trading in which they noted “high-frequency trading represents approximately 50% of the resting orders around the best price, which suggests that high-frequency traders may be contributing to filling gaps in short-term supply and demand. Where this occurs, high-frequency traders can provide a benefit to wider market users.”
We hope that as regulators and institutions develop their understanding of high frequency trading and its place in modern market structure, the benefits of HFT will be further understood and the distinctions between good and bad practice will become easier to identify and better-regulated.
The views expressed in this blog post are the personal opinions of the author and do not necessarily reflect the official policies or positions of the FIA European Principal Traders Association or the Futures Industry Association.
