Oh No – Another Post About High Frequency Trading?

HFT is a topic I’ve beaten to death previously on this blog, and also extensively in comment threads on other blogs around the vast confines of the Internet.  This morning, I read an interview with Chris Sparrow,  an “expert” in high frequency trading, that surprised me in how much I disagreed with some key early points.  Let’s dive right in:

IndexUniverse.eu: Chris, what’s wrong with the current structure of equity markets?

Sparrow: The current market structure is fundamentally unfair, since different participants have unequal temporal access to information.

To put it simply, if other people can see that your order has been filled before you can, or that there’s been an update to a price quote before you are able to see it, you’ll lose confidence in the market.”

Gah – no – that’s not the problem at all.  It’s a fact of physics that someone will always have the information first.  I covered this more than two years ago and I see no reason to rehash it.  Read my prior post. Then read this one, where I talk about several more ways the retail investor has it much better than in the Good Old Days in terms of equality of information… Then you can read this post on that same topic.   The current disparity of “temporal access to information” has been narrowed from 20 or more minutes to fractions of a second.   That cannot possibly be the problem. Q.E.D.

As for “losing confidence in the market” – this is another huge pet peeve of mine.   We keep hearing about how investors are/(should be) losing faith/(confidence) in our markets.  The main reason they’re losing confidence in our markets is because people keep telling them that they should lose confidence in our markets.  Guess what – the retail investor positively DOES NOT CARE if some HFT algos want to quote a stock a million times a second.  Seriously – it has ZERO impact on us – we can’t even see it!  If people weren’t telling you that you should be afraid of these computers sending out millions of quotes a second, you wouldn’t even know it was happening.

next question:

IndexUniverse.eu: Is the fragmentation of equity market trading between different venues a concern?

Sparrow: I’m not concerned with fragmentation per se, as competition between trading venues is good. What’s missing is synchronization and coordination.”

This one kills me, because I think that fragmentation is PRECISELY the problem.  And synchronization/coordination are not missing – that’s precisely the roll that many HFT algos fill: arbing prices and maintaining order across trading venues – a necessity due to fragmentation!   Market fragmentation occurred when firms began competing with the NYSE.  This competition is a good thing, in theory,  but some of the consequences are problematic.  I’d certainly prefer to have one venue where all orders are sent for execution.   Maybe it would kinda look like the old Instinet.   The impossible question is, as a former colleague and current big-swinging-dick in electronic executions asked me rhetorically via email: “How do you put the fragmentation genie back in the bottle?


IndexUniverse.eu: What led you to identify the current trading system as a problem?

Sparrow: I’ve done a lot of work in transaction cost analysis (TCA). I was looking at a particular order and for purposes of comparison wanted a proxy for the Canadian equity market. For this I used the iShares S&P/TSX 60 ETF (TSE: XIU).

It turned out that there were a million quote updates in this ETF during a single trading day of 23,400 seconds. Why do we need so many updates? They impose significant storage requirements on everyone, take up significant network bandwidth and arguably do not contribute significantly to price discovery.

All the trading data that’s being produced is an externality on the whole market. We all have to buy bigger hard drives, bigger servers and network switches just to process the data, even though there’s little extra benefit in doing so.

Again, I disagree with this – the people who are incurring the costs of processing this data are the people who care about trading on a micro-second level.   I don’t care – I’m not buying hard drives.  The average retail investor doesn’t care – he can’t even see this stuff going on behind the scenes.   He’s the beneficiary of all these HFT participants trying to scalp a 1 penny bid/ask spread.

So anyway, Sparrow asks “Why do we need to many updates?”  Ah hah – yes – a valid criticism, and a reasonable point, which is often phrased in a different way, such as “are we really getting much benefit from this continued technology arms race?”   That’s a fine question, and my first response is: we are probably not getting much marginal benefit, but so what?  These guys (the HFT players) are paying for the costs of improving the speed of our entire system.   The ones who want the speed are bearing the costs of improving it.   We may no longer be seeing significant benefits, but I don’t see significant costs/negatives either.  Also see Tyler Cowen’s post yesterday at Marginal Revolution related to this topic. (Note to readers: I highly recommend reading the comments of Cowen’s post, where a number of readers weighed in with very mature, experience arguments about why you shouldn’t be afraid of HFT).

Now, on to possible ways to improve our current market structure.  I’ll let Mr. Sparrow give you his idea:

Sparrow: My suggestion is the following. At a single point in time, which we call T0, you open up the order book and allow participants to enter orders, without anyone being allowed to see them. You and I can enter orders up to a second point in time, called T1, at any venue we choose, but we can’t see or react to each other’s activity.

At T1 (plus, in practice, a small delay to ensure the order entry session is closed) the trading venues try to match as many buy and sell orders as possible and to establish a single, market-wide clearing price. At that point all trades get printed and the residual state of the book, consisting of unmatched orders, gets published, as would the location of the unmatched orders. In other words, competition between trading venues could continue.

And by ensuring that matching orders get cleared, we do away with some of the problems that exist under the current system of continuous trading. For example, in the current structure it’s very easy for there to be “locked” markets, where the bid price at one trading venue equals the offer price at another venue, or “crossed” markets, where the bid at one venue exceeds the offer at another. These situations could be eliminated through co-ordination of the matching process.”

Ok – I’m game – I’m willing to ponder this idea.   Since I already said there may not be much benefit to accelerated “continuous” trading, the first thing we need to try to figure out is what, if any, are the negatives to making trading less continuous.  Generally, I think it’s better to give market participants more freedom rather than less, but I certainly wouldn’t argue that trading once per second would be a problem for our markets.

Would it be more problematic if we decreased the frequency even less?  If we had 10 trades per hour? or 2?  or 1 trade per day?  I’ll leave that as a hypothetical thought exercise for The Reader, but my point here is that I have no problem considering Mr. Sparrow’s recommendations for improvement, even if I disagree with him on the “problematic” state of the current market structure.



Index Universe Interview With Chris Sparrow: Time To Rethink A Broken Market

Tyler Cowen: What Are the Social Costs of High Frequency Trading?

Someone Will Always Have the Data First

Dear Knight, Thank You.  Dear Themis, Relax

Young Whippersnappers Have No Idea

The Little Guy Has Nothing To Complain About




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