High-frequency trading. also called HFT, typically uses algorithmic trading to execute trades at a high speed. Algorithms spot opportunities where ultra fast trades (measured in seconds or fractions of seconds) in huge volumes can net a profit. While proponents of HFT claim that it has helped to enhance market liquidity and narrow the bid-ask spread, many feel that the improved market liquidity is illusory and HFT really renders markets more fragile. In this article we will discuss whether high-frequency trading really improves market liquidity. (Related reading Strategies And Secrets Of High Frequency Trading (HFT) Firms )
Liquidity is best described by three measures—size, price, and time. When liquidity is high, investors can successfully trade a large order close to the current price and within a short time period. One popular measures of liquidity is the bid-ask spread.
According to a New York Stock Exchange brochure. “liquidity is the depth of market to absorb buy and sell interest of even large orders at prices appropriate to supply and demand. The market must also adapt quickly to new information and incorporate that information into the stock’s price.” Liquidity is an important characteristic of a good market as it inspires confidence among the participants.
The trend over the past decade suggests that the use of HFT trading has greatly increased in the market and at the same time, so has liquidity. The big question remains, is correlation a sign of causation? Does HFT enhance market liquidity while reducing transaction costs ?
Before regulatory changes introduced the alternative trading system (ATS ) around 2000, exchanges like the New York Stock Exchange worked on a double auction system where buyers and sellers were matched by traders and specialists. The use of electronic trading systems gave birth to a new system—high-frequency trading for buying and selling securities. Most estimates suggest that HFT now makes up 50-75 percent of the total equity trading volume. HFT traders include both small, less-known trading firms as well as large investment banks and hedge funds.
High-Frequency Traders as Marketmakers
Some strategies used in HFT do unarguably provide liquidity to the markets. For example, HFT traders can play the role of a formal or informal marketmakers. As a marketmaker, HFT
traders post limit orders on both sides of the electronic limit order book simultaneously, thus providing liquidity to market participants looking to trade at that time. Most marketmakers are looking to earn the bid-ask spread by buying at bid and selling at ask.
Since marketmarkers undergo the risk of losing money to an informed counterparty, they need to update their quotes frequently to reflect the current information. This changes constantly with price movements in a related financial instruments (like ETFs or futures) or other submissions and cancelations. Thus as a response to the need of continuous updating, HFT marketmakers end up submitting and cancelling many orders for every transaction. The incentive to earn a liquidity rebate in the U.S. equity markets has led many to formally register as liquidity providers while others continue as informal marketmakers. In this sense, HFT enhances market liquidity and reduces trading costs because of narrow bid-ask spreads.
Hot Potato Volume
The opponents of high-frequency trading feel that whatever liquidity HFT creates is superficial because the securities are held for a very brief period (seconds or fractions of a second) before being sold back again into the market. Most of the time, securities are bought and sold very frequently between high-frequency traders until they are bought by an investor. Opponents say there is thus no ultimate creation of liquidity but a mere facilitation for order execution.
HFT results in what is called hot potato volume. Positions are being ping-ponged between high-frequency traders and the other marketmakers. Thus there is the creation of great volume and no concurrent depth. For orders to be absorbed, buyers must hold their positions for a longer time than just a few seconds. (Related reading Is High-Frequency Trading A Fancy Term For Cheating? )
The Bottom Line
With more than a decade in existence, high-frequency trading is now more or less an accepted part of the stock markets. There is a consensus that, on average, HFT has added liquidity to the markets and reduced trading costs. As HFT firms are slowly brought under the regulatory cover, there is a better chance that any unethical practices will be spotted and discouraged. (Related reading How The Retail Investor Profits From High Frequency Trading )