Another Defense Of HFT, Promptly Refuted By New York Fed
An article today in Time magazine with the unassuming title "The Truth About High Frequency Trading" is the latest in the spin campaign defending High Frequency Trading. The story is well known- liquidity, and innocent market makers who only care about their spread without positional exposure or underlying bias.
Marketmaking explains why high-frequency trading accounts for over half of all U.S. stock volume: Every transaction begins with a trader offering to buy or sell. These days, more often than not, that trader is a high-frequency marketmaker.
Yes, high-frequency marketmakers profit from the bid-ask spread, and yes, other traders will benefit from being able to get in and out of the market more easily, but what about those who are not actively trading? Most of us aren't concerned with having a tight bid-ask spread at every moment, since we are longer-term investors interested in holding a portfolio — not continually trading.
While some assumptions in the article are naively assumed to be facts, the key flaw is that market makers simply provide liquidity with no regard for the underlying direction of the stock they make a market in. And, as author Ari Officer explains, these very market makers are almost exclusively computers who have taken over ultra fast liquidity provisioning.
Ironically, Exhibit A refuting Ari's argument comes not from a place like Zero Hedge, but from a much more "objective" and traditional venue: the New York Fed itself:
A staff report paper released a week prior to the Time article titled "Are market makers uninformed and passive? Signing trades in the absence of quotes" comes to a conclusion which debunks Mr. Officer's Utopic conclusions about naive and uninterested market makers. And we quote:
When we look at the cross-section of market makers and relate the extent to which their initiated trades are inventory increasing to their profits from trading, we find a significant and positive relation. Our results provide evidence against the market maker being just an uninformed liquidity supplier. On the contrary, he seems to actively speculate on private information signals.
Not only that but the following:
We therefore conclude that for locals and duals on announcements days there indeed is a positive and significant relation between inventory increasing trades and profits from trading, with the strongest relation for the dual traders. These results are consistent with the market makers building up a position after the announcement, and earning a profit from this. The market makers that have the highest percentage of inventory increasing trades earn the highest profits. This relation is strongest for dual traders, the group of market makers with the additional information set of observing what orders customers bring to the market.
The New York Fed apologizes for bursting Time's (and other people's) bubble, but the obvious (and naive) observation that market makers are unconflicted, disciplined managers of inventory positions is singly refuted. In fact, reading between the lines, market makers are active participants in hoarding techniques pushing stocks in either direction upon observations of client traffic flow, exacerbating bid/ask discrepancies due to a lack of supply or demand in either direction.
The NY Fed's conclusion taken one step further as it applies to HFT algorithms, which advocates will claim provide just these "market making" services yet on a much larger scale, explains why so many independent observers disclose their distrust of market making activities by algorithms that, courtesy of Flash and other order flow exposing tricks, are all too well aware of which "private information signals" to analyze when making instantaneous decisions on which way to "speculate."
And when these "market makers" are in control of 70% of stock volume on any given day, to claim that stocks trade on anything even remotely connected to fundamentals, is pure lunacy. Although as the market is now an SEC-sponsored casino, why should anyone care? After all the market is only up, day after day after day. Any puke (which incidentally brings out all the volume) becomes a case of everyone rushing for the exits until some "market maker" decides to reverse the flow, and return "stability" as other participants step to the sidelines. And just like any Ponzi, as long as the overall direction is up, everyone is happy, whistleblowers like Markopolos be damned.
Full New York Fed paper presented below: