Voluntaryist Reader: Is High-Frequency Trading Detrimental to Markets?
The prevalent view in the media over the last few years has been that high-frequency trading (HFT) is dangerous for the financial markets and that regulation is necessary to ensure market stability. From a voluntaryist perspective I will argue that HFT — as any other technological advancement and voluntary interaction — is beneficial to the markets and that most of the undesirable phenomena for which it is blamed (market instability) are the result of unintended consequences from regulation.
Good article. You might want to read the insightful comment just published below. :D
"When the King is far the people are happy." Chinese proverb
For Alexander Zinoviev and the free market there is a shared delight:
"Where there are problems there is life."
abskebabs: Good article. You might want to read the insightful comment just published below. :D Thanks abs. Thoughtful comments. Of course, anyone is welcome to comment/critique. Malachi, if efficient devices for energy transformation, transport, and storage are devised it is entirely possible that energy units (calories) become a medium of exchange. Not quite there yet, though. | Post Points: 5
I think HFT goes much deeper than what you presented. For example this:
"Many HFTs will make near-simultaneous trades on different exchanges and profit because of the delay in one of the exchanges. An example will help me explain: let’s use the NASDAQ and EDGE exchanges, and say that ABC stock is trading at $1.00.
The HFT will send a bunch of quotes (offers) to NASDAQ and EDGE, trying to sell ABC stock at $1.01. Once the NASDAQ order is accepted, the HFT can simultaneously cancel the $1.01 sell order on the EDGE exchange and replace it with a buy order at the original price of $1.00. EDGE immediately accepts that $1.00 order, because its system has not caught up to the new price of $1.01, and the HFT’s net position becomes zero.
This is possible because of latency, which is jargon for delay in the system. The net result is, the HFT captures a $0.01 arbitrage.
By scalping this tiny amount from many trades, the profits add up quickly."
And this:
"It is, which is why investors need to understand how to protect themselves. One of the most important tips I can give you is to never enter stop-losses into the market. There are algos designed to sniff out stop-losses and manipulate them against you."
For a very insightful interview with HF trader see this: http://www.zerohedge.com/news/interview-high-frequency-trader
Interesting you'd publish now...Wenzel just had a writeup a couple weeks ago:
And here's more:
Understanding High Frequency Trading
NYT Spotlights High Frequency Traders
Max Keiser and "Tyler Durden" on High Frequency Trading
Inside A High Frequency Trading Firm
A Very Confused Leon Cooperman or or Does He Have a Secret Agenda?
Prime, that's pure arbitrage and it has been done for thousands of years in everything traded under the sun -- from donkeys to equity shares. If it's so easy and lucrative perhaps you, too, should try it. :)
Anyway, I don't see how that is hurting anyone or is detrimental to the markets. Pure arbitrage is a process by which price anomalies are eliminated and price information spreads across the market. When you go to buy IBM shares on one exchange, pure arbitrage ensures that you get the 'market' price reflecting the supply/demand from all exchanges.
JJ, I read EPJ and ZeroHedge and am aware of their differing views on the subject. HFT has been in the media for years now, especially after 2008.
People write/talk about what other people like to write/talk, I guess.
I didn't say it was anything new...I just thought it was interesting that he had recently made a post specifically on that subject, and so did you...and figured people might be interested in more literature.
z1235's article seems nice. I like it. Nice blog!
My father used to do this for a while but it wasn't making enough money to be worth it, and computers were slower back then. My tip: you need alot of money to invest to make it worth it. If you don't have enough money, the returns from HFT are too low relative the risk.
Being alert to and sensing and using differences in time before people notice that several prices for the same things exist in the same market due to ignorance, pure arbitrage involves pouncing on such differences before anyone else notices, buying at lower price to sell at medium price to person who sells at highest price. It is a stabilizing mechanism for markets according to Hayek (1948) and Kirzner (1973); it causes the market to have fewer different prices simultaneously for same thing, so that nobody sells scarce resources for less than people are willing to pay according to present preferences, leaving more of the resource available in the future for people (a price that is too low shall result in present consumptiuon of the resource being so great that less is left over for the future than people who consume it now prefer and is contrary to their own preferences had they possessed all the information) and thus more efficiently use scarce resources: the price difference, when acted upon narrows, first of all, and is also revealed, and thus eventually disappear, causing simultaneous prices for the same thing to converge toward whatever price best reflects people's preferences according to what they are willing to pay. Of course, high price also converges to the medium price, as consumers who are willing to pay the higher price buy whatever they want, leaving on the people who value it less. Thus, instead of a high price and a low price simultaneously existing and confusing producers who wish to determine what and how much to begin producing, goods are sent to be sold to consumers ultimately at and only at the highest price consumers are willing to pay, whatever that price is in the immediate present.
All the complaints against high frequency and speed trading are basically made by some firms against other firms having faster computers, more people, and more money, allowing to the catch price differences first, and get the most out of them, closing such price differences already just when other firms have only noticed them and get ready to act on them. Its people complaining against competition that, however, makes the best use of resources and removes pricing error (pricing deviating from preferences by being too low or too high, this is, not consistent with preferences regarding distribution of consumption of the good over time and present valuation) due to ignorance by distributing information.
All such trading is beneficial, because like all arbitrage it directs consumption and production to most closely correspond to consumer preferences and smoothes out changes in consumption in production to most closely follow changes in consumer preferences, which otherwise result in several different prices all other things equal appearing over time due to ignorance by present producers of near past changes in preferences of consumers.
Of course socialists dislike it because they dislike arbitrage and trading in the first place.
Many businessmen dislike it because they can't pull it off themselves given the competition. Instead of quietly finding other things to do, they complain.
Edit: Maybe I should just sign up to contibute on that blog, which seems well designed, actually. For instance, I'm presenting at the Austrian Student Scolar's Coference in February, so I might post a write up on some themes touched.
Market has 2 different meanings.
It can be an enterprise that mediates and regulates trades between traders, i.e. a securities exchange.
And it can be the abstract social process by which prices emerge and goods and services are produced and allocated.
"Detrimental" makes more sense for the first meaning.
For the people running these exchanges, allowing high frequency trading to take place can be profitable or not, depending on their market model, i.e. how they profit from the trades they are hosting.
But for the market process "as a whole", detrimental does not make much sense. The market process has no preferences nor intentions and nothing can be detrimental or favorable to it.
All we can say is that high frequency trading will be used by traders and allowed by people regulating the trades insofar as it seems useful for them to act like that.
Detrimental or beneficial refers to consumer preferences, which division of labor and trade attempts to satisfy. Otherwise people would neither specialize nor trade.
The market, which is voluntary, is beneficial by reason of being voluntary by both sides in every exchange. Each prefers the outcome of the trade to not trading. The goods exchanges change not at all, but people get pleasure by trading (Condillac; Gossen).
Since HFT is part of the market, not a result of violent intervention or coercion, it too is beneficial from the perspective of the preferences of individuals comprising society.
You are saying that given your ethical beliefs, HFT seems to be ethical.
That's ok. But that's not very important anyway.
What's important is what HFT can do to the P&L of the NYSE, for example. If it hurts their P&L, probably the NYSE will look for ways to limit it's growth.
Whether it is by imposing internal rules or through lobbying new regulations, they will seek some solution to their problem with HFT.
A stock exchange, or any other security exchange, is a business whose profits come precisely from their ability to generate an environment of rules and conventions where traders consider fair and profitable to make their deals.
If they understand that they can achieve that by limiting HFT, that's what they will do, regardless of whether HFT is voluntary and therefore socially benefical or not.
By a similar token, one could say that trading on insider information "should" not be against the rules of an exchange, much less a serious felony, since there's no distinct coercion.
That can be a topic for some interesting philosophy among non-practicioners.
However, the people organizing most stock exchanges, and also the traders they serve, think otherwise, and that's why they invest a lot in mechanisms that detect and punish this kind of fraud.
So now we have computers trading on system noise, oops discerning and exploiting statistical patterns in market data, and guess what? Computers are/will be at least as good at losing money as Day Traders. And their cost benefits over a Day Trader are not as significant as one might suspect as the Day Traders bring their own cash to the table while the giant banks bring newly created Federal Reserve Notes, counterfeited money.
And just like with the Day Trading, when there were some large firms doing it and finding success that makes everyone else jump in and do the same. Eventually the little arbitriage games they are playing end up being losers.
And as usual the best political solution about this is to do nothing. The best solution for all except the HFT users, which will never happen, would be to dissolve the SEC and allow these exchanges to become free-for-alls with the exchanges setting their own rules about Day Trading, High Frequency Trading, Market Making, Insider Trading, etc. And if we do whats best the benefit will be that these arbitriage systems will be even shorter lived than they are currently.
You are saying that given your ethical beliefs, HFT seems to be ethical. That's ok. But that's not very important anyway. What's important is what HFT can do to the P&L of the NYSE, for example. If it hurts their P&L, probably the NYSE will look for ways to limit it's growth. Whether it is by imposing internal rules or through lobbying new regulations, they will seek some solution to their problem with HFT.
Incorrect. Not ethical beliefs. All voluntary exchanges are beneficial to both sides, otherwise they would not have done them (remember: voluntary is the key word). Has nothing to do with ethical beliefs, mine, yours, or anybody. Economics is value free. People have preferences. They act to satisfy them. And the market is just a series of trades. HFT, as one of kind of trade, is beneficial.
The preferences of both sides are different. It does not matter what their preferences are nor what my preferences are. So long as the exchange took place and it was voluntary, then it was beneficial to both sides, a Pareto Improvement.
If they seek new regulations, then they are socialists and fools and knaves. Because it has nothing to do with ethics. It has to do with maximizing want-satisfaction, according to their preferences. Erroneous action decreases want-satisfaction in terms of their own preferences despite being intended to increase want-satisfaction. Unless socialism is advertised as "objective virtue", in which case it is just a religion.
I am not a trader by any stretch but from what I have read about HFT, it has definitely put me off from entering the market. It just seems like too much risk when these billion $ organisations are HFT. I know there are still some good investments but it can be quite unsettling to know that I will always be one step behind.
It's been around since late 1990's if a company could get a fast connection and the computers (very expensive). It's just easier now. And so more companies do it now. It has always required many resources to get any benefit from (remember, tiny gains per transaction, huge risk, so you need to operate with millions of dollars and have a few million to spare in case your account requires a deposit in case you screw up and need to recover.
So I guess yes, HFT is not possible for the most part for people like me and you, unless you have lots of capital in reserve. I would not engage in HFT because I simply am not able to, and indeed cannot compete with firms that do have the funding and the staff.
Due to a lot of people I know that have these jobs, 3 out of 5 people in the stock market are programmers, often physicists by education who cannot get other jobs (or like the pay), working to get and keep the computers and proprietary software running 23 hours a day without error, something that is in part due to the growth in HFT.
Yeah, right. You are saying that because HFT is voluntary, whatever voluntary means to you, it is beneficial. That's pure ideology.
In the real world, any financial trade is not only between some part and some counter part. If it takes place in some exchange, the exchange is involved too, and the exchange has its own agenda, that includes not only short term profits but reputation building through assuming responsibilities towards other users of the exchange.
I agree, economics is value free, but it's you who is impregnating economic analysis with your ideological predispositions, not me.
If they seek new regulations, then they are socialists and fools and knaves.
How come this is not value judgement?
People who actively seek new regulations generally have something to gain by setting up these regulations and the incentive structures they create.
If you think they are "socialist fools" you are being very naive and idealistic.
Jack Roberts: I am not a trader by any stretch but from what I have read about HFT, it has definitely put me off from entering the market. It just seems like too much risk when these billion $ organisations are HFT. I know there are still some good investments but it can be quite unsettling to know that I will always be one step behind. It is hard to compete against big players in seeking generic stat arb oportunities in the microstructure of the marketplace, since they have so much more resources to find and seize them. But it's not impossible, if you happen to have a very original idea. And of course, it's not also the only way to make money trading. If you have better understanding of some sector of the market and can identify when something is being undervalued, you can always seek profits there. Austrian economists claim the interest rates are off, and this is the cause of many long run disturbances in the markets. Well, if that's so, it should be possible for some austrian trader to put some skin on the game and make money using such perceptions. That seems to be what uber-bearish oddballs like Mark Spitznagel, Nassim Taleb, Jim Rogers and Peter Schiff do, or at least what they want others to think they are doing. "Blood alone moves the wheels of history" - Dwight Schrute | Post Points: 20
Isn't there some small fee the index charges for any trade? It seems to me hft would be impossibel if the index charged a nominal fee for each trade. How do the indexes make money? If they charged a penny per trade, hft would be less an issue.
To Anenome, there is a fee per trade (not per units of stock traded), several dollars, plus a commission of the entire amount of funds moved. Always. No matter if gain or loss. That is why if you trade but get less than around 30-40 per cent profit, you are below the bottom line and lose money even when it appears you gained money.
Next.
ToxicAssets asked why many people who defend HFT don't engage in HFT. I already answered the question. I'll say it again, YOU NEED TENS OF MILLIONS OF DOLLARS TO PLAY WITH OR YOU WILL LOSE MONEY! Don't have it then don''t do it. The risk is high because the computer is the one that makes errors and sometimes wrongly identifies when a trade is possible. In that case, you will lose lots of money because you had to invest lots of money to get any reasonable gain. Remember, you need millions of stocks, else penny per stock is nothing and exchange transaction fee + commission places you below the bottom line: exchange transaction fee + plus commision is not a few pennies.
They are beneficial if you actually have the resources to engage in them; otherwise, stick to regular stocks, because your effective demand (I want a helicopter, but I can't pay for it, so I'm not on the demand curve for helicopters and can't trade money for helicopters since I don't have any money) is too low to enter the HFT market.
If you having nothing to give in exchange for something else in a trade, then of course you can't trade and won't benefit by trade, SINCE YOU ARE NOT IN FACT TRADING.
Like the old Soviet anecdote: the store has lobsters for 1 ruble, but they are very small, and other lobsters for 5 rubbles, but they are very large, so what should I choose! Oh, I can't make up my mind! Now, if I actually had 5 rubles, I don't even have 1 ruble ...
Finally.
ToxicAssets seems to be entirely suffering from absence of training in and lack of understanding of the method of science. He or she seems to believe there is neither such thing as science no objective true, that every description of a dynamical system has some AGENDA. (This is easily shown to be nonsense: because the proposition "truth does not exist" is either true, in which case it is false, or false, in which case it is false. Proof by dilemma, the opposite proposition, "true does exist" is necessarily true. Thomas Aquinas ... )
It's a mathematical question of utility maximization, given the preferences of both parties. Science describes the behavior these people would have to follow to satsify THEIR OWN goals, WHATEVER THEY ARE. Observe. IT IS INVARIANT TO CHANGE OF PREFERENCES.
IF it is voluntary exchange of things, which is the case IF AND ONLY IF the two parties have opposite preferences OTHERWISE they would keep what they have, THEN it is preferred over the alternatives by the two parties, OTHERWISE they wouldn't have done it. The preferences of the observer do not enter in the equation, which is an IF ... THEN ... proposition, which is true by proof by contradiction.
IF by hypothesis A = B, THEN AC = BC, BECAUSE C = C, OTHERWISE AC ~ BC, which would imply that C ~ C, which is a contradiction, or A ~ B, which is contrary to hypothesis. THEN ... is an objective inference, necessarily true, because it is literally identical to the initial conditions.
In this case, the only initial conditions are that TWO PEOPLE HAVE DIFFERENT PREFERENCES AND MEET. Then objective inference, that they shall trade and be better off FROM THEIR OWN PERSPECTIVES, is identical to that premise, hence implied by it and true whenever the premise is true.
Therefore, as HFT is a kind of trade, so it BENEFICIAL FROM THE PERSPECTIVES OF THE PEOPLE WHO TAKE BOTH SIDES. As an observer, I merely describe the situation, my own preferences don't enter in to the equation.
To show that what I said is not correct, you must falsify the premise and prove this "everyone's preferences are identical." In that case and only in that case trade is not beneficial every time from the perspectives of the people involved. But is this really the case?
This is as trivial as it get.
All science is objective, as is logic-mathematics, too, positive, instead of normative. There is no agenda, any more than the equations of special relativity describing identity of diagonals or rigid bars during coordinate shifts have any agenda or the mass of some sub-atomic particle being such and such is some agenda.
Anenome: Isn't there some small fee the index charges for any trade? It seems to me hft would be impossibel if the index charged a nominal fee for each trade. How do the indexes make money? If they charged a penny per trade, hft would be less an issue.
An index is just a bundle of stocks or other securities whose value is a weighted average of the individual components.
It's just one of the papers that can be bought and sold.
The major players are the individual investors, the mutual or hedge funds and the investment banks, the brokerage firms, and the exchange itself, as well as the clearing houses and the governmet agencies that survey and regulate the activities.
The investors are the easier to understand. They make money by buying low and selling high, or by owning dividend paying shares.
Investment banks also provide services for clients, like writing exotic derivatives and swaps, or planning an public offer or a merger or a takeover or a block liquidation for a large investor.
The broker acts like a bookmaker. The investors usually contact a broker when they want to buy or sell something, because it's not always possible to directly find a counterpart to a given trade.
He tries to earn a profit by balancing the sell and buy side of his accounts through the setting of a spread (difference between bid and ask).
They also make money by charging trading fees, but they are usually very low or zero for institutional traders, and through loans of securities to be used in short sell positions.
There are also clearing houses and firms, that guarantee counterpart risks for some deals by setting up accounts and margins deposits for participants in transactions that will be netted in the future.
The trading facility, or exchange, is the company that lists all these peoples and the papers they trade, and set the rules of engagement, and provides all sorts of public interest information. Some services are free of charge and others are payed for. They are the hosts of the party. They can also shut down the system for a while, when things become too weird and chaotic and people start jumping out of the windows.
Trades can take place in a traditional trade facility, where companies and commodities are listed and all trades are quoted.
Or trades can be done over the counter, through direct arrangements between parts or in alternative trading facilities, like multilateral trading facilities where rules for quoting limit orders are different.
A good deal of HTF action goes on inside some of these MTF, specially those that with lot's of trading privacy and where orders are automatically and anonimously routed by matchmaking algorithms, a.k.a. dark pools of liquidity.
ToxicAssets: An index is just a bundle of stocks...
An index is just a bundle of stocks...
I meant 'exchange' I just couldn't think of the word right then.
I've actually held a series 6 and 63 in the past, so I'm fairly knowledgeable... despite my failure to remember the word and being too lazy to worry about looking it up right then :P
why would a person volunteer to lose money due to lag in a system?
let the systems set up their own rules, some may be against hft, and those that break the rules would be cheating and not trading.
thelion:ToxicAssets asked why many people who defend HFT don't engage in HFT.
Not so sure I have asked that.
I, for one, defend the use of modern brain surgery by certified physicians but I'm not sure it would be a good idea for me to try it myself.
I already answered the question. I'll say it again, YOU NEED TENS OF MILLIONS OF DOLLARS TO PLAY WITH OR YOU WILL LOSE MONEY! Don't have it then don''t do it. The risk is high because the computer is the one that makes errors and sometimes wrongly identifies when a trade is possible. In that case, you will lose lots of money because you had to invest lots of money to get any reasonable gain. Remember, you need millions of stocks, else penny per stock is nothing and exchange transaction fee + commission places you below the bottom line: exchange transaction fee + plus commision is not a few pennies. They are beneficial if you actually have the resources to engage in them; otherwise, stick to regular stocks, because your effective demand (I want a helicopter, but I can't pay for it, so I'm not on the demand curve for helicopters and can't trade money for helicopters since I don't have any money) is too low to enter the HFT market. If you having nothing to give in exchange for something else in a trade, then of course you can't trade and won't benefit by trade, SINCE YOU ARE NOT IN FACT TRADING. Like the old Soviet anecdote: the store has lobsters for 1 ruble, but they are very small, and other lobsters for 5 rubbles, but they are very large, so what should I choose! Oh, I can't make up my mind! Now, if I actually had 5 rubles, I don't even have 1 ruble ...
I'm quite sure I never disputed any of that.
What I said is that the trades taking place in formal exchanges aren't simple agreements between the seller and the buyer of the asset being traded, but they have to comply to a general framework that affects a lot of other people, including those running the exchange itself.
And if, for whatever reason, these people consider that HFT is detrimental to their business, they will look for ways to hinder its use, even by other traders.
It's like playing poker. On most tables, you can't show your cards to another player during a hand or lend him money to make some bet. "This isn't Nam, Smokey… there are rules.".
If you wanna play with the other kids you will have to follow their rules too.
Maybe most traders don't like HFT techniques because they can easily manipulate the market before everyone else have enough time to know what's happening. I don't know, but it's possible they think that way and because of that they decide to ban it.
I'm not particularly attacking it, by the way. I worked on market microstructure noise, order book modeling and arbitrage and smart routing at some point, and if anything I really dig HFT.
But some exchanges, like NYSE and Euronext for instance, don't like us doing certain things, and if they decide to ban us that's life. It's like being banned from a casino because you happen to know how to count cards on Black Jack. It's a cost of doing business...
You can stick to your simplified view of the universe if it pleases you, just try not to distort what I've said to fit whatever straw man you are used to target.
thelion:ToxicAssets seems to be entirely suffering from absence of training in and lack of understanding of the method of science.
Well, that's probably true, I tend to be very stubborn and I dislike complicated stuff like "method of science".
He or she seems to believe there is neither such thing as science no objective true, that every description of a dynamical system has some AGENDA.
A given scientific description might very well have an agenda if you consider the people engaged in elaborating and publicizing such a description.
Sometimes the agenda of the scientist and popularizers is to propose the solution of a problem that is interesting to other scientists in the community, or to propose new problems without solution that might be interesting to look at.
And through the posing and solving of problems that are linked with the understanding of how things work that science and technology advances.
But sometimes our lack of understanding of a topic may create opportunities for pseudo-scientific expositions that elaborate confused and nonsensical pseudo-problems and pseudo-solutions, and create an illusion of genuine science.
And when these things are too complex these illusions can last for long.
Most of the time, it's not conscious malice, but the fact that these scientists are themselves victims of the appeal of the misconceptions they invent.
In economics there are many examples of this pattern.
And even though I cannot say for sure, one good example still alive of this seems to be the whole hysteria about global warming.
thelion: his is easily shown to be nonsense: because the proposition "truth does not exist" is either true, in which case it is false, or false, in which case it is false. Proof by dilemma, the opposite proposition, "true does exist" is necessarily true. Thomas Aquinas ...
his is easily shown to be nonsense: because the proposition "truth does not exist" is either true, in which case it is false, or false, in which case it is false. Proof by dilemma, the opposite proposition, "true does exist" is necessarily true. Thomas Aquinas ...
As much as I love these metaphysical quagmires, I really don't have the time.
Just consider that these things can be a little more complicated than that. When you have purely abstract self-referential statements you can have "necessary truths" but also paradoxes (like "this stament is a lie") that shake the whole logical structure that you're trying to build.
It's something known even before Aquinas, or Aristotle for that matter. They were first considered by the ancient greek sophists. These foundational problems with logics were eventually better understood due to the modern works of Frege, Russel and Whitehead, Wittengenstein, Tarski and Godel.
And this goes for formal logics. Because the epistemological relationship between formal concepts and concrete phenomena is a whole other can of worms. There lies the ancient problem of induction, and the general epistemological attitudes defended by several schools of thought regarding this problem are manifold.
The mainstream tradition however is the perspective intiated by scottish lumieres, specially Hume, and further expanded into the negationism perspective by Popper in the XX century. In very short form, they say you can never positively prove some theory, you can only try to falsify it somehow.
But it's generally assumed that any relationship between formal models of abstract concepts and statements and the real things they try to represent can never be proven logically "true", and the only thing we can strive for is approximative correspondence and comparative performance between alternative representations for a given phenomenon.
But even this epistemological attitude is a belief that cannot be proven. It's an infinite game of recursion and abstraction as you can see.
These things are hard as fuck and many people went insane from attacking such problems directly.