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February 23, 2018

Making Markets or Scurrying Away Just When Needed: A Study of HFTs

By Lev Bagramian

High frequency traders (HFT) and their supporters have for a long time claimed that HFT adds liquidity to the market and provides market-making that’s beneficial to investors, stabilizes prices, and narrows spreads.  A recent study, using data from the Australian Stock Exchange (ASX), which covers nearly 90% of all securities trade in Australia, paints a different picture: In reality,  HFT firms add the wrong kind of liquidity and often fail to meet their market-making responsibilities. 

The study shows that HFT firms add liquidity at times when it is least needed, and reduces liquidity at times when it is most needed for stable markets.  HFT firms supply liquidity when the markets are already liquid (i.e., “to the thick side of the order book”) and remove liquidity when there is scarcity.  These results directly contradict the oft-stated justification for high frequency trading: that HFT firms supposedly act as modern-day market-makers, helping securities’ prices remain stable and keeping markets liquid.  But while market-makers are supposed to step-in when others are fleeing – acting like firefighters entering a burning building when everyone else is running for the exits – the study shows that HFT firms are the first to flee, leaving retail and institutional investors trapped in unstable and sometimes collapsing markets. 

The study also shows that, according to the criteria set by the authors, over 40% of the HFT firms’ profits are at the expense of institutional and retail investors.  This wealth transfer from retail and long-term investors to computer-driven HFT firms is what erodes investor confidence in the markets. 

Finally, the period under study included ASX’s introduction of a new, ultra-low latency connection type, allowing those willing to pay a premium to access the exchange faster than other participants.  The timing of the introduction of this new feature allowed the authors to validate what similar analyses have shown in the past: When HFT firms can gain faster access to markets and data, their trading advantages increase, and the problem of ill-timed or “reverse” liquidity is exacerbated.

For more about the study, see this additional blog post at Themis Trading. 

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