A new paper on high-frequency trading (HFT), published by the European Central Bank (ECB), adds further weight to the growing body of evidence suggesting HFT has a broadly benign to positive effect on markets.
That’s not to say that, at all times and under all circumstances, this type of trading activity is beneficial. However, the research — sponsored and published by the ECB but developed by a group of independent academics (Brogaard, Hendershott, and Riordan) — does indicate that HFT facilitates price efficiency both on average and on the highest volatility days.
This contribution to price efficiency is achieved by trading in the direction of permanent price changes (impounding information in prices) and trading in the opposite direction of transitory pricing errors (reducing short-term volatility or “noise”), the authors conclude. Such “noise” makes it difficult for investors to determine the true price, increasing the likelihood of trading in the wrong direction. So, by reducing the noise component of price changes, HFT reduces the risk of investors buying when they should be selling, or selling when they should be buying.
The paper indicates that these benefits to price efficiency are realised through high-frequency traders’ liquidity-demanding orders (marketable orders that take liquidity from the order book). But balanced against these benefits are the adverse selection costs imposed on other traders from HFT liquidity-supplying orders (e.g., resting limit orders). The authors note that high-frequency traders supply liquidity when they have better information, such that when other investors trade against those limit orders, they are likely to be on the wrong side of the market (against the direction of expected market movements) in the short term.
Such adverse selection risk may be exacerbated by trading in dark pools — another issue that is under the microscope of policymakers in Europe and officials in the United States. Dark pools enable investors to minimise information leakage and reduce market impact. Yet the corollary of more trading in dark pools is that the lit market — the exchange limit order book — becomes more homogenised by high-frequency traders.
Returning to the ECB paper, the authors also examine the process of price discovery and find that, due to their use of sophisticated technology for processing information and trading quickly, high-frequency traders predict price changes over horizons of less than 3 to 4 seconds. Additionally, HFT is correlated with two sources of public information: macroeconomic news announcements and limit order book imbalances. The data presented by the authors indicate that high-frequency traders are net suppliers of liquidity around macroeconomic news announcements, suggesting that these firms provide liquidity when it is most needed (i.e., under stressed conditions). However, the results also suggest that on balance, high-frequency traders trade in the direction of order book imbalances — that is, demanding liquidity on the thinner side of the order book or supplying liquidity on the thicker side of the book. Therefore, the data are somewhat mixed with regard to high-frequency traders’ ability to stabilize market movements.
As the above discussion implies, it is rarely easy to form a complete and decisive view on HFT. Indeed, the aforementioned considerations relate to price discovery and efficiency only — the ECB paper does not explicitly examine measures of market quality such as order book depth or institutional investors’ execution quality, for example.
Nonetheless, the research is an important contribution to the policy debate that again illustrates several positive aspects associated with HFT, particularly its beneficial role in terms of impounding information in prices and reducing pricing errors. Given the market’s dependence on the liquidity HFT provides, policy makers should focus on measures to bolster system safety and resiliency rather than punitive measures to prohibit HFT activity. As European deliberations over the revisions to MiFID (Markets in Financial Instruments Directive) heat up, investors must hope that legislators give prominence to empirical evidence over commercial or political considerations.
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