07.15.2016

Who you callin’ HFT? Five Misconceptions Surrounding “HFT” (By Cameron Smith, Quantlab)

– Modern Markets Initiative Member Guest Editorial by Cameron Smith, President, Quantlab Financial

True or False: High Frequency Trading (HFT) is a type of firm

False.  HFT is a general term referring to a form of algorithmic trading that occurs at a rate of action of which only computers are capable. It is a tool not a trader.  This point was made quite well in a 2015 joint report by five government agencies that examined trading behavior by distinguishing how different market participants used HFT as opposed to how HFT itself traded.  Although there is no defined category of “HFT,” misuse of the term is often seen in analysis and punditry today.

While professional traders have always traded on short-term fundamentals, advancements in technology made it possible to efficiently implement established trading strategies using high speed algorithms.  The problem with the term “HFT” is that it makes it sound like it’s a unique strategy or group of actors when, in reality, computerized algorithms are used in every liquid instrument, from FX to futures to equities, by all types of professional traders ranging from bank FX desks to independent principal trading firms.  These days, any order sent by a bank, or routed by a broker, will most likely be HFT.  So despite efforts by many otherwise, it doesn’t make sense to talk about “HFT firms.”

True or False: Liquidity is only provided by market makers who use passive orders and quotes

False.  Without both sides to the transaction there wouldn’t be a trade at all; no one side is more valuable.  However, some have posited that professional traders that post orders provide more value to the market.  The reality is that liquidity is provided by both parties to a transaction, whether as buyer or seller and whether as a result of posted quotes or by interacting with resting orders.  The most liquid, lowest-cost markets are those where there are no barriers to participation by a wide range of liquidity providers, regardless of how they trade.  This is an important point given the vibrant debate among policy makers in Europe and beyond on the nature and availability of liquidity in the markets.  The word “liquidity” simply describes the degree to which an asset can be quickly bought or sold without affecting the price.  In all markets, this has always required professional intermediaries to offset short-term supply/demand imbalances.  But, contrary to the focus of recent regulation, liquidity isn’t only provided through simultaneous two-sided quotations. We need a broader concept of “liquidity provision.”

Attempting to distinguish between the value of passive and active orders is even more futile given that both firms and even strategies often use a mix.  For a market maker to manage its inventory – i.e. how much stock to hold and at what price to buy and sell – it often actively accesses liquidity in order to close out a position it entered.  For example, when a market maker quoting in ETFs is hit on the bid, it may manage its risk by executing a hedge through the sale of the underlying ETF components using aggressive limit orders.  This combination of both passive and active order flow makes up the market maker’s supply of liquidity and helps ensure that assets like ETFs track their net value.

In fact, studies show that approximately half of the liquidity provided by the professional trading community manifests itself by interacting with posted quotes.  This is misleadingly often called “taking liquidity” but is really providing liquidity to a resting limit order placed by an investor that chose not to incur the costs associated with crossing the spread (which can be meaningful, especially in stocks with wide tick sizes).  While passive orders play a valuable role in establishing market price, the majority of permanent price discovery comes from active-spread crossing strategies.  Active strategies often involve the use of quantitative models that form an opinion of fair value, and where this deviates from market price, cross the spread.  As this type of trading means that a successful trade must both pay the spread and cover the cost of exchange fees (often higher than for “makers” due to the absence of rebates), it’s intuitively clear that active orders are better at accurately predicting the direction of price moves.

True or False: HFTs have very short holding periods and don’t hold positions overnight

False.  First, as pointed out in myth #1 above, there is no group known as “HFT” so there are no positions to attribute to them!  But, if we are discussing professional traders that are using computerized algorithms, there is no one holding period since these firms employ hundreds of different strategies. A firm doing a simple arbitrage between futures and equities may hold a position for a brief period.  Similarly, a market maker posting a quote may quickly trade out of a position, but can alternatively lay off the risk quickly (by trading a related product) while actually holding both products for hours if not days or weeks.  At the same time, other firms may structurally hold positions for minutes, hours or days.  In fact, studies show that active HFT strategies are more likely to hold positions intraday and overnight (with position sizes around five times larger than passive HFT strategies).  Such strategies (i.e. those that result in the taking and holding of positions, rather than in immediate entry and exit) are an essential component of market stability.  With investors using a mix of passive and active strategies, both passive and active professional trading strategies improve the market in terms of the bid-ask spreads, depth, price impact and lower transaction costs.

True or False.  HFTs are not large participants in the Treasury or FX markets

False. When HFT is properly understood as the use of computerized algorithms by professional traders, then it’s evident that banks are already using HFT in the Treasury and FX markets.  The real question is, therefore, whether the FX and Treasury markets will continue to be the exclusive domain of banks that trade with their clients in a non-competitive environment using HFT strategies or whether FX and Treasuries will migrate to transparent and competitive exchanges where non-bank HFTs can also participate.  The dramatic reduction in investor trading costs on equity markets around the world reflects the benefits of competitive and transparent exchange marketplaces with all types of HFT participants, ranging from banks to independent proprietary trading firms.

True or False: Unlike primary dealers, HFTs have no obligation to remain in the market (particularly during turbulent circumstances) and may withdraw at their discretion

False.  First, only market makers that are registered as such are obligated to stay in the market. Every market maker on an exchange is using a computerized algorithm; therefore many HFT-enabled strategies are, in fact, obligated.  These obligations, however, are usually calibrated to reflect what firms are already doing: the reality is that firms will trade when it makes economic sense to do so and not at other times.  The good news is that when markets are volatile or active, professional trading firms have inherent economic incentive to continue trading.  Just as an umbrella salesman may make the bulk of his sales on rainy days, professional traders do more trades in volatile markets when demand for liquidity is highest and when stocks are more likely to be displaced from fair value.  During the most volatile times in the history of markets (e.g. 2008-2009, August 24, 2015, BREXIT, etc.), independent professional trading firms increased their participation.  This makes intuitive sense once it is understood that most professional traders use elements of mean reversion, which perform well during market turbulence, while at the same time dampen market volatility.  Most recently, the BIS paper Who supplies liquidity, how and when?, echoed the finding that professional traders increase participation during the times the market needs it the most.

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