From
The Physics of Finance and
Medium:
Financial firms that specialize in “high-frequency”
trading (HFT) are now buying and selling stocks, futures, foreign
currencies and many other assets with computer algorithms operating on
timescales less than 1 millisecond. That's more than 1,000 trades a
second. Modern markets have become complex ecologies in which millions
of these “algos” compete all the time, and with advancing technology,
10,000 trades per second is just around the corner. More than half of
all trading now takes place this way, and there's no end in sight to
this “arms race” to ever faster speeds.
Non-financial people may rightly wonder: Why? Does it make sense? Is it fair, sensible, or possibly dangerous?
Indeed,
it CAN BE dangerous, as such trading was directly implicated in the
infamous Flash Crash of 6 May 2010, as well as in many “mini” flash
crashes since then. Stock prices of course move erratically, but at
least they used to move continuously; now stocks often jump
discontinuously by several percent in a fraction of a second. Some
experts, such as quantitative finance guru Paul Wilmott, have
argued
that high speed computer trading will bring on the next great financial
disaster. Others, such as the Bank of England's Andy Haldane,
point out
that while high-frequency trading in ordinary times makes markets more
liquid and therefore efficient, it also makes them more volatile and
potentially explosive in times of stress.
I've written
before
about these risks associated with HFT, and remain convinced that we
know very little about the things that might go wrong, especially as HFT
becomes ever more dominant across different markets globally (see
this worrying article,
for example). Still, I'm not at all against technology when it can help
us, if we can clearly understand how it does help us, collectively,
rather than just the few parties who use it. So, I want to point out
some far-from-obvious positive aspects of HFT, highlighted by
recent research by physicist and finance expert Austin Gerig of Oxford University.
HFT
firms don't go around telling people how they're trading. This secrecy
has helped fuel controversy around what they do and also made it hard
for researchers to tease out how exactly HFT activity affects markets.
This is what Gerig has tried to do, using a special dataset supplied by
NASDAQ, which reveals much greater detail on HFT trading activities.
Perhaps the most striking thing he finds is that a primary effect of
broad HFT activity is to “synchronize” security prices across financial
markets. This means, for example, that if the price of Coke suddenly
changes – because of fluctuations in sugar prices, perhaps – this will
be followed almost instantaneously by similar price changes in other
related securities such as Pepsi.
“Synchronization is a
gargantuan task,” Gerig points out, given the huge number of stocks and
other assets and the links between them, plus all the myriad
derivatives products the values of which are directly tied to those
assets. It's a task, he notes, that is “tailor-made for HFT as it is
profitable for the firms that do it and can only be done with high-speed
computerized trade.”
Ok, so HFT helps
synchronization. So what? Using a standard model of financial markets,
Gerig goes on to show that price synchronization is broadly good for the
market, as it makes prices more accurate and thereby reduces
transaction costs. Specifically, improved price accuracy leads to cost
reduction because liquidity providers – market makers who stand ready to
buy or sell at fixed prices at any moment – have more confidence that
they won't be “picked off” or taken advantage of by someone out there
who has better information....
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