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.