Chris Sparrow

    BOOKMARK AND SHARE

    Mon, 28 Nov 2011 02:35:27 GMT           

    Much attention has – and continues to be – focused on the impact of high frequency trading.

    Many market participants have raised red flags regarding the practice, claiming that HFT leads to flickering quotes and disappearing liquidity. The pro-HFT camp claims that HFTs benefit the market by adding liquidity resulting in reduced spreads and lower volatility.

    Given these diametrically opposing viewpoints and the attention given to the practice, why, after more than two years of debate and discussion, is the impact of HFT still unclear? The answer is that they are both correct; HFT can simultaneously benefit and harm the market.

    Put simply, HFT is not a trading strategy. It’s a business model.

    HFT shops use technology to implement high frequency, low latency trading strategies. They also use services provided by marketplaces such as co-location and direct market data feeds. HFTs can be defined by their business characteristics, which include carrying minimal overnight positions, having extremely short holding periods and using powerful computers connected to low latency networks to submit and cancel orders.

    These tools and services can be used in many different ways. There is a fairly broad spectrum of HFT strategies, with each having a different impact on the market.

    These include:

    • Statistical arbitrage
    • Cross-asset/inter-listed arbitrage
    • Latency arbitrage
    • Pattern recognition
    • Electronic liquidity provision (rebate arbitrage)

    Some of these strategies, such as statistical arbitrage, reduce volatility, which, through the perspective of a buy-side institution, provides a net benefit to the market. Electronic liquidity provision (ELP) results in tighter spreads as ELPs compete with each other to earn a rebate from a trading venue. That’s a benefit to the retail investor. Other strategies, such as pattern recognition, prey on the buy side by trading ahead of institutional order flow. Latency arbitrage results in flickering quotes, leading to frustration on the part of traders trying to access this fleeting liquidity.

    The problem that arises when discussing the impact of HFT is that some of these strategies provide a benefit while others are more nefarious. Any general discussion of HFT results in averaging across disparate sub-strategies. Examples of this occur when articles are written touting the benefits of HFT but describing a specific HFT sub-strategy such as statistical arbitrage. This approach leads to headlines that tend to confuse rather than clarify the impact of HFT.

    The solution is to narrow the discussion to the impact of specific HFT strategies. By being more precise, methodologies can be tailored that address the specific impacts of HFT strategies rather than trying to address the impact of a general set of strategies.

    In the same way, products and trading techniques can be developed to counter specific strategies. Smart order routers can be constructed to counter latency arbitrage and algorithms that are easy to recognize can be modified to minimize their footprint in order to counter pattern recognition strategies.

    One point that is generally agreed on is that HFTs possess potent weapons in the forms of technology, market access and intellectual capacity. Traditional market participants must evolve their techniques to avoid being picked-off by “bad” HFT strategies and to take advantage of “good” HFT strategies.

    Part of the solution is to institute techniques to measure the impacts of the various HFT strategies and then act on these measurements to ensure optimal trading results. The other part of the solution is to utilize products that have been developed to address the impacts of detrimental HFT strategies.

    To move forward in the debate about HFT and its impact on the market, we need to understand the impacts of the specific strategies being employed and avoid generalizing statements that apply to all strategies.

    Otherwise, the pro-HFT camp will continue to talk about strategies that heave a clear benefit to the market while the anti-HFT camp will continue to focus on strategies that exploit the existing market structure to pick off natural liquidity providers.

    In short, we need to stop talking about HFT and start talking about their strategies.

    This article originally appeard on the Tabb Forum: http://tabbforum.com

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