A study of high frequency trading by a Columbia Business School professor released earlier this week concluded that HFT-related strategies are “making markets better, not destabilizing them.”
The study, conducted by Professor Charles Jones, who is the Robert W. Lear Professor of Finance and Economics at Columbia’s Business School, is not based on reviewing existing research. The study is termed the “first meta-analysis on HFT” in that it surveyed approximately 30 theoretical and empirical papers on the topic.
The core findings, which echo previous academic studies, are that HFT enhances market liquidity, reduces trading costs and makes stock, prices more efficient. “Better liquidity lowers the cost of capital for firms, which is an important positive for the real economy,” the study states. It also points out that the lower cost of automation can be passed onto investor in the form of narrower bid-asked spreads and commissions.
However, the research was funded by a grant from Citadel, LLC, one of the largest high frequency trading firms, which would be impacted by an regulatory actions to curb or tax HFT.
“At a time when HFT has become a subject of regulatory focus, it is important that policymakers, practitioners, and researchers dispassionately assess the hard data of accumulated evidence on HFT’s impacts,” stated Jones in the press release summarizing the findings of his analysis.
The study looks at HFT as a style of trading in which firms typically trade hundreds or thousands of times per day for their own account, with a typical holding period measured in seconds or minutes. It also defines HFT as a subset of all-algorithmic trading, which is generally defined as the use of a computer algorithm to make decisions about order submissions and cancellations.
In response to commentators who have argued that HFT could make markets more fragile, leading to the possibility of extreme market moves and episodes of extreme illiquidity, the study analyzes the May 6, 2010 Flash Crash. It notes that the CFTC and SEC identified many HFT firms during the Flash Crash and found they initially stabilized prices abut were eventually overwhelmed and in liquidating their positions, exacerbated the downturn. Professor Jones notes this is a common response by intermediaries that also occurred in less automated times such as the October 1987 market crash and a similar market crash in 1962. The study notes that short term individual stock price limits and trading halts which have been introduced since the Flash Crash, and appear to be a “well crafted regulatory measure that should prevent a recurrence.”
[HFT: A Clear and Present Danger?]
Acknowledging that regulators in the US and abroad are considering a number of regulatory initiatives, the study weighs the pros and cons of these potential measures. Specifically, it considers consolidated order-level audit trails and admits that with HFT, “malfeasance is possible in order submission strategies, so regulators need ready access to order level data from multiple venues.” With respect to order cancellation or excess message fees, it notes that Nasdaq is currently imposing these fees in the U.S, but it is too soon to measure the effects. The study warns that “order cancellation fees will almost certainly reduce liquidity provision away from the inside quote, reducing depth.” It recommends that current initiatives should be studied carefully before broader message-based fees are considered. In addition, the study also advises against proposals for minimum order exposure times, where orders could not be cancelled for 50 milliseconds. It also advises against securities transaction taxes, which it warns will have dire consequences such as increasing volatility, worsening liquidity, increasing trading costs and causing trading to move offshore.