Streetwise Professor

August 15, 2011

An Illuminating Contrast: HFT Are Not Sunshine Soldiers

Filed under: Economics,Exchanges,Financial Crisis II,Politics,Regulation — The Professor @ 2:30 pm

High frequency trading firms came under heavy fire in the aftermath of the May 2010 Flash Crash because they largely withdrew from the market shortly before the Crash.  Indeed, the lack of liquidity (which is nowadays largely provided by HFT firms) was likely a necessary condition for the Crash to occur.

In light of that, and of last week’s market craziness, it is therefore quite interesting to read this:

The stock market’s fastest electronic firms boosted trading threefold during the rout that erased $2.2 trillion from U.S. equity values, stepping up strategies that profit from volatility, according to one of their biggest brokers.

The increase from Aug. 1 to Aug. 10 over their 2011 average surpassed the 80 percent rise in U.S. equity volume, showing that high-frequency traders made up more of the market during the plunge, Gary Wedbush, executive vice president and head of capital markets at Wedbush Securities, said in a telephone interview. Wedbush is the largest broker supplying bids and offers on the Nasdaq Stock Market, according to exchange data.

“We’re seeing a tremendous amount of high-frequency trading,” said Wedbush, whose company is one of the biggest execution and clearing brokers catering to high-speed firms. “Their business is a trading business, and volatility creates far more opportunities. Some of their algorithms and automated systems are trading two, three or five times as many shares as they would have in a more normalized volatility environment.”

It is therefore incorrect to say that HFT firms are Sunshine Liquidity Suppliers who head for the hills when things get volatile.  Sometimes HFT reduce the amount of liquidity they supply.  Sometimes they increase it.  And volatility alone is not enough to spook HFT firms.  Indeed–and this shouldn’t be surprising, really–volatility can be a huge profit opportunity for them.  Note, moreover, that their profit-spurred entry almost certainly reduces volatility below what it would be otherwise and improves efficiency.

One should hope, therefore, that regulators and others who blame HFT for every market outcome they don’t like will take this more recent experience into account in order to develop a more mature understanding of HFT, and use that understanding to develop sensible policies that encourage beneficial HFT.  Policies that don’t throw the baby out with the bath.

A study of what caused the differences between the first two weeks of August and the Flash Crash could be quite illuminating.  Market making, whether old school on the floor of an exchange or new school on computer at high speed, is vulnerable to toxic order flow–that is, order flow driven by private information.  Any market maker who wants to survive has to have the ability to determine when order flow is toxic and when it is not.  Old school traders could intuit the likelihood that the guy who wanted to buy from or sell to them was trying to pick them off because he had better information.  HFT uses algorithms to try to sniff out such opportunistic order flow.

It is pretty clear that on May 6, 2010 HFT algos were flashing warning signs that the order flow had turned toxic,  and they cut back as a result.  It is also clear that despite all the volatility in these days of Downgrade and Debt Crises, the algos are not picking up evidence of an increased intensity of privately-informed trading.  As a result, the HFT firms are sufficiently confident that the risk of being picked off is low that they can profitably supply liquidity.

One interpretation of this is that HFT firms are primarily responding to market conditions, rather than creating them.  One implication of this is that regulators should try to develop tools that would allow them to pick up the same warning signals that HFT algos do in order to anticipate potential market disruptions a la 6 May 2010.  This would permit the implementation of precautionary policies that could reduce the likelihood and intensity of Flash Crashes.  This would be a far better policy than micromanaging HFT trading through things like order time limits or commitments to make markets even when that is unprofitable.  Micromanagement is likely to be counterproductive as it raises the costs of supplying liquidity, and inducing exit of market making capital–which would make prices more volatile during conditions like those that have prevailed this month.

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  1. Concern over “toxic” order flow may be one reason for a market maker to curtail their participatation or raise spreads. However, during the flash crash concerns about trade certainty appear to have been a big factor affecting participation. After-action interviews with firms (found in the joint staff report by the CFTC and the SEC)showed that many market makers lacked confidence that trades would not be “busted.” In fact, many trades in the equities markets were arbitrarily busted on May 6 using an after-the-fact standard. Uncertainty about the prospect of busted trades creates an unacceptable risk for market makers and if they are prudent they can be expected to curtail their participation in the market. Since the flash crash, regulators in the US have appropriately focused their efforts on working with various trading venues to implement clear error trade policies. Perhaps the participation seen last week by HFT market makers during an extremely volatile market is an indication that traders have more confidence that their trades will stand (or that they at least know what the bust rules will be).

    Comment by Jim Overdahl — August 15, 2011 @ 3:36 pm

  2. Hi, Jim. Good to know you’re a high frequency reader (HFR) 🙂 Interesting background. Was there a difference in the perception of the risk of trade busting between, say, individual equities and index futures? Ex post the former were, as you note, often busted, the latter were not. Since the liquidity dried up on ES too, right before the crash, your explanation would require HFT firms to believe there was considerable risk of busting ES trades too.

    The Easley-O’Hara-Lopez de Prado research shows that there was an upsurge in order flow toxicity on 6 May, before the Crash.

    Obviously, the two explanations are not mutually exclusive. It may well be the case that these factors combined to make the collapse in liquidity especially severe on 6 May. To the extent regulators and exchanges have intervened to reduce fears of trade busting, that’s a good thing.

    Your comment illustrates, moreover, the reputational effects of seemingly “fair” actions. Important thing to remember.

    Thanks, and hoping all’s well.

    The ProfessorComment by The Professor — August 15, 2011 @ 4:19 pm

  3. Yes, as you point out, there was a difference in perception of trade busting likelihood between the e-mini futures and individual equities. Although liquidity vanished quickly in each market, it returned quickly in the futures market (after the stop logic pause) but didn’t return for 15 minutes later on the equity side. Like you say, there could be more than one explanation (and possibly interaction between explanations) but the data combined with market maker interviews are consistent with the idea that trade certianty (or lack of it) was an important part of the flash crash story.

    Comment by Jim Overdahl — August 15, 2011 @ 5:41 pm

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