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2011-01-07 16:08:42
I've been an avid follower of /. for some time now. I've gained a lot of
insight from reader responses, which are generally well thought-out, mature,
and reasonable. On the topic of market microstructure, however, I feel /. falls
woefully short. I cringe when I read comments that sound like something from
Zero Hedge.
I work in HFT. I make markets. Obviously, there is an incentive for me to talk
about all the good things HFT brings to the world. However, I also believe that
we serve a function in the market. Perhaps not vital, but still a service
nonetheless.
What do market makers add to the market? They're willing to stand on the other
side of your trade. They serve a vital function to the market and we can trace
them back to the specialist days on the floor. Let's all agree to start from
there.
What do HFTs add to the market? Now this is where you have a large divide in
opinion, and rightly so. Some HFT firms will engage in predatory behavior that
is unfortunate, including quote stuffing and price manipulation. I am not
writing to absolve all the bad things that many HFT firms do. However, in my
view, ideally, HFT market makers add these factors: immediacy and continuity.
As an investor, you can go up to a trading terminal at any time in the day and
someone (most likely an HFT firm) will be there to take the other side. That is
immediacy. You also have access to price discovery that is happening every
fraction of a second. That is continuity. These are ideal situations, and not
every HFT adds these values. Firms that only remove liquidity are often not
providing immediacy. Firms that manipulate prices are usually not providing
continuity.
If you think, "HFT's will run at the sign of chaos!" I agree with you. The
better, smarter, and faster firms will continue to stay in the market, but only
up to a certain point. Why should anyone stand in the way when a big
institution sells 75,000 ES contracts? We trade and provide liquidity so long
as it's profitable. If you have a problem with that, you have a problem with
capitalism. How do you possibly incentivize participants to absorb tail-end
risk?
If you think, "But investors don't care about 30 microseconds!" I agree with
you. The short reaction times are there so that we can manage risk. It
indirectly adds value to the investor because it allows us to manage risk
better, which allows us to provide really tight markets. Think about it. We're
standing there for anyone in the world to trade against all the time. Adverse
selection is the name of the game. Back in the specialist days, spreads were
sometimes in dollars. Now they are in pennies, and in many liquid stocks,
exactly a penny. I assure you -- if we ever move to a system that taxes each
trade or throttles latencies, you will see spreads widen out immensely because
it's harder to manage risk. If you impose a limit on the minimum life of a
quote, you will see spreads widen because there's risk in standing in the
middle of the highway for too long.
If you think, "But company values don't change every 30 microseconds!" I agree
with you again. It's the possibility that they could change that necessitates
high reaction speeds. Company valuations are stable -- on average. But once in
a while, some information is leaked that damages the company's reputation or
some big institution decides to buy a ton, and you're left with a huge position
that's going against you. Should we stand there and absorb that flow even when
it's not profitable?
The last point is probably the biggest factor in a gating system where trades
only take effect every N seconds. You can only update your position every N
seconds, so as a market maker, you're essentially putting out a lot more risk.
Some firms will be smart about risk management and be able to provide tighter
spreads and make money for themselves. Some firms will not and they will go out
of business. Almost certainly, firms would widen spreads to protect themselves
from adverse selection.
The gating system also will not eliminate the arms race. Let's suppose we have
an auction system that matches buyers and sellers every 2 minutes. Who gets
matched first? If the system is based on price-time priority, then there is an
incentive to be at the front of the line. Not only do you want to be at the
front, but you also want to be on the right line. That sets up demand for
faster computers and faster connections. If the system is pro-rata, which
matches large orders first, it raises the barrier to entry for smaller
companies with less capital. There was a comment here about randomized
matching. It would still not completely remove the arms race. You still want to
be able to cancel orders in case bad things happen and whoever cancels as close
to the deadline can process the most information.
Maybe there is a reasonable solution, but please do not simply throw out ideas
like "let's throttle speeds" and "let's tax traders" and think that's all there
is to it. Market makers would love to provide liquidity and get paid for it. We
don't widen spreads or decrease liquidity out of spite -- we get out if we're
losing lots of money.