Guest Post: An Austrian View On High Frequency Trading

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Submitted by Martin Sibileau from A View From The Trenches

An Austrian View On High Frequency Trading

In our last letter, we made some comments on high-frequency trading. Today, we want to briefly analyse, from a macroeconomic perspective, the underlying ideas thrown in its favour, as well as the impact this activity has on the capital markets. Why is this important? Because more than half of the trading volume in equities in the main world exchanges is driven high-frequency trades today (More than 70% of volume in the US exchanges alone).

What is high-frequency trading? We will never exhaustively address this issue here. We recommend that you do your own research on the subject. There are numerous articles on this topic. High-frequency trading (HFT) consists in using sophisticated technology to trade securities. It is highly quantitative, employing algorithms to analyze incoming market data. HF investment positions are held only very briefly, with HF traders trading in and out of positions intraday tens of thousands of times. The important feature is that at the end of a trading day there is no net investment position. Processing speed and access to the exchanges are critical.

HFT strategies can be broadly thought in terms of three main groups: Those that provide liquidity, those that trade headlines and those that trade statistics. The statistical ones are the easiest to understand (at least for us): They are based on technical analysis, correlations. The headline strategies seek to profit from momentum trading, filtering information that describes intra-day action in the exchanges. The so-called liquidity strategies are either based on market making (to profit from bid/ask spreads) or from rebate trading. Operationally, HF traders collectively send millions of orders, the most part of which (we understand above 90%) are cancelled before they are even hit. This often causes delays in the exchanges that receive them, potentially creating arbitrage opportunities in those stocks that trade in multiple exchanges.

Two main factors have been put forward in support of HFT. We will quickly dismiss them:

a) HFT provides liquidity to markets

We think this point has been misunderstood, because at a macro level, one must not refer to the liquidity of a particular asset, but of liquidity in general or, more properly, liquidity preference, since liquidity is not a condition intrinsic to any asset, but the result of preference by market participants.

Indeed, HFT may and does provide liquidity to a particular asset, but it is a different thing to say that HFT provides liquidity to the market, at an aggregate level. At an aggregate level, the liquidity preference of market participants is what matters. If they want to be liquid, they have the means to do so either by holding money or by changing it for commercial paper or short-term obligations of borrowers with a solid and steady cash-flow stream. Collectively, for market participants to allocate some of its savings to liquid assets, there is no need to see millions of quotes a day, for instance, on a risky junior mining company with assets overseas, thereby creating the illusion that the junior mining equity space is liquid.

Market participants do not need to see the universe of liquid assets expanded to satisfy their respective liquidity preferences. And if they have to get their savings out of an asset which until a minute ago seemed liquid but now is not, they will be able to do that with or without HFT, because there is no reason to believe that under a shock, the HFT bid will not disappear in a nanosecond, making the situation even worse.

Having said this, it is clear that the impact of the quoting activity by HF traders generates a distortion in the capital markets and particularly, in the capital structure of an economic system. Companies that, given the nature of their businesses, would have been forced to raise secured long-term bank debt to fund their capital expenses before the influence of HFT, may now find it easier and cheaper to raise equity. And those with investable assets captive in the system (i.e. registered funds, 401ks) will now fall prey to very risky projects, under the belief that they are protected by electronic stop-loss orders. Banks that might have been willing to provide secured lending to these equity issuers, will now find that they can only bid for less profitable working capital lines, under the belief the loans are protected by stock pledges! And it gets even worse: Those who invest in this equity may decide to pledge it under, say a 3x coverage ratio, to borrow funds and invest in even riskier, “more profitable” assets!

The liquidity argument in favour of HFT is just one more Keynesian version of the notion that inventing purchasing power ex-nihilo can get us somewhere better, but this time, applied to the capital markets in particular.

How does HFT invent purchasing power? The liquidity premium embedded in assets that wouldn’t otherwise be liquid or would not even exist, is the purchasing power we refer to. For this same reason, those who defend HFT now fear that by prohibiting it (just like their fear to prohibit fractional reserve lending) we will see a collapse in valuations. Unfortunately, that collapse will eventually take place, only still bigger and affecting global capital markets.

b) HFT facilitates the process of price discovery

 What media and those in favour of HFT commonly refer to price discovery is nothing else but algorithms sniffing stop losses, causing volatility in the process. There really isn’t anything particular about HFT with respect to pricing, which human beings cannot achieve on their own. Throwing orders to exchanges that are immediately cancelled to test floors or caps on the price of a certain asset cannot be credited with price discovering. Indeed, efficient markets are those which always challenge valuations and in the process, prevent the misallocation of resources from further growing. But the challenge of valuations always represents the challenge of their underlying assumptions: Sales, leverage, productivity, management, etc. Shaking the nest, the way HFT does (with the sudden introduction of millions of quotes) to “discover” key levels is hardly the feature of a healthy capital market.

Let us bring an analogy: Human lives are not traded. Yet, if a criminal kidnapped somebody’s daughter and asked for a ransom, he would certainly be “discovering” the price of her life: The parents of the girl, having offered all they had in immediate liquid assets, would have told the criminal what the price for their daughter is. Now, this is exactly what algorithms do when testing price levels in the absence of economic news, as we have painfully seen across a myriad of asset classes.

This is not a healthy way to price assets, because just like the parents had never thought of trading her daughter for money, market participants not challenged by economic developments but by millions of fake orders, were forced to do so. A trade actually took place in an otherwise illiquid market but…what will happen next time? Neither the daughter will be left alone by the parents nor our market participants will be there for the criminals to profit from them, which is why retail money will keep flowing out of the stock exchanges (the system) as long as the status-quo is not changed.

Perhaps too, our fictional criminal will regret not having given the father more time to liquidate more assets, but of course, that would have come at the cost of higher risk. There is no difference between the criminal’s short-term line of reasoning and that which keeps HF traders from keeping positions for longer than seconds or minutes. Therefore, if we were really thinking about price discovery, neither our criminal nor HF traders did discover the true price. In the end, all we ended up with was volatility that will exponentially increase, as the exchanges impacted by HFT see participants leave to over-the-counter markets (like real estate?)…Is this the actual reason behind the high percentage of HFT volume in exchanges? Is it because we are leaving the exchanges all to HF traders?

The market crashes driven by HFT, like that on the NYSE in May 2010 or the recent one affecting the Knight Capital Group should be a big wake-up call. This is a new technological change which the Austrian School of Economics should further analyse. We, at “A View from the Trenches”, just wanted to leave our two-cent contribution with our thoughts. We leave with an interview on the subject, to Scott Patterson, author of “Dark Pools”, dated August 8th

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Sun, 08/12/2012 - 11:02 | 2698676 Silver Bug
Silver Bug's picture

HFT has to go. It is destroying our system.

 

http://silverliberationarmy.blogspot.ca/

Sun, 08/12/2012 - 12:08 | 2698761 Dr Benway
Dr Benway's picture

Excellent article!

 

Especially interesting: HFT's effect of capital market distortion toward equity, and the mispricing of said equity due to the fake liquidity premium (and in the case of manipulative algos outright fixed prices, one might add).

 

HFT just fits so naturally in with TPTB. Desperately the financial wizards are trying to dream up yet more byzantine ways to keep cooking the books, to keep kicking the can down the road, to delay the inevitable asset price correction to *true* market value.

Sun, 08/12/2012 - 11:07 | 2698685 HD
HD's picture

I'm all for HFT. I'm a busy man - why should I have to wait months or years for Wall Street to screw me out of my retirement money the old fashioned way? I want to take advantage of the miracle of modern technology and be wiped out in mere nanoseconds.

 

Sun, 08/12/2012 - 11:12 | 2698692 otto skorzeny
otto skorzeny's picture

I'll just save all the ZH posters alot of time and say "I'm stackin' PMs and lead with my worthless fiat"

Sun, 08/12/2012 - 11:47 | 2698737 DoChenRollingBearing
DoChenRollingBearing's picture

Nice summary!  + 1

Sun, 08/12/2012 - 12:55 | 2698820 francis_sawyer
francis_sawyer's picture

So basically...

HFT = a "canoeing trip"

Sun, 08/12/2012 - 11:55 | 2698743 sunaJ
sunaJ's picture

Thus, thine ears betray thee if indeed that is all thou dost hear.

Sun, 08/12/2012 - 11:21 | 2698708 resurger
resurger's picture

lol

Sun, 08/12/2012 - 11:10 | 2698688 otto skorzeny
otto skorzeny's picture

"price discovery"- what a quaint idea. these HFTs will wipe out 5000 points on the Dow in a matter of seconds

Sun, 08/12/2012 - 12:19 | 2698773 Dr Benway
Dr Benway's picture

To be fair, the greater destroyer of price discovery, and possibly causing a greater distortion in prices, is the forcefeeding of billions of dollars into the sharemarket as governments round the world copied the Chilean model of pension saving. This was of course a bonanza for those already with shares, or those working in financial services as there suddenly were fees galore. By law, a huge amount of cash was forced into shares, not specific shares but just the entire market. All this of course compounded by the usual villains of leverage and speculation.

Sun, 08/12/2012 - 11:10 | 2698689 DoChenRollingBearing
DoChenRollingBearing's picture

Barron's DC pro Jim McTague writes a piece suggesting a change to slow down HFT in this weekend's edition.  He confirms that the various exchanges DO rent out coveted space at their server farms to others who want to be there VERY close to the exchages' own servers (similar to what I have read here at ZH).  Apparently many of these very fast trade trades can be done in less than a millisecond, McTague looks with favor on slowing this down to 10 milliseconds.

http://tinyurl.com/9bjprqk

Sun, 08/12/2012 - 11:15 | 2698694 otto skorzeny
otto skorzeny's picture

North Jersey if full of these HFT servers trying to get as close to the exchange servers as possible. also- I'd like to swim in a dark pool w/ Lauren Lyster

Sun, 08/12/2012 - 11:49 | 2698739 DoChenRollingBearing
DoChenRollingBearing's picture

otto you must have some really nice coffee today...  Two good, pithy comments!  + 1

Maybe + a lot more re dark pools and Lauren Lyster, oh wait, I'm married...  You take her!

Sun, 08/12/2012 - 14:12 | 2698933 knukles
knukles's picture

Not nice to sin in your mind along with Jimmy Carter.
Mrs. Roller Bearing might get ideas about alternative uses for your product.... as in ouch.

(high frequency millisecond impact)

 

Sun, 08/12/2012 - 11:12 | 2698693 Long-John-Silver
Sun, 08/12/2012 - 11:14 | 2698696 Motorhead
Motorhead's picture

Mmmmmm, look at those gams of Lauren Lyster.

Sun, 08/12/2012 - 11:19 | 2698700 otto skorzeny
otto skorzeny's picture

she blows those old pigs on CNBC away. although I am fond of Maria Bartiromo.

Sun, 08/12/2012 - 11:30 | 2698722 Motorhead
Motorhead's picture

I always wondered if Maria is fond of tequila shooters.

Sun, 08/12/2012 - 19:34 | 2699563 Papasmurf
Papasmurf's picture

You have low standards.

Mon, 08/13/2012 - 00:28 | 2700133 Nobody For President
Nobody For President's picture

Pussy Riot! Pussy Riot!

Sun, 08/12/2012 - 11:15 | 2698697 ebworthen
ebworthen's picture

HFT is risk avoidance, a kind of perverted anit-investment Frankenstein.

It works against price discovery and liquidity to make momentary gains by jiggering both.

It is no wonder that it causes flash crashes as the battle is to make money from nothing rather than to invest.

Combined with humans who are unnacountable to the rule of law, both taking advantage of those who are trying to make real life decisions to save and invest their blood, sweat, and tears, HFT is an intestinal parasite - a pox on society.

 

 

Sun, 08/12/2012 - 11:21 | 2698707 resurger
resurger's picture

If the market has an artificial liquidity worth 56%, what else is left?

Sun, 08/12/2012 - 11:52 | 2698745 Papasmurf
Papasmurf's picture

The other computer.

Sun, 08/12/2012 - 11:28 | 2698716 Winston Churchill
Winston Churchill's picture

True parasites seldom kill the host.

HFT's have killed this 'market'.

The Algo sized exits will be way to small for any remaining humans.

Sun, 08/12/2012 - 14:09 | 2698846 slewie the pi-rat
slewie the pi-rat's picture

hey, eb!

imo algo HFT is simply the computerized result of the bid-ask spread going human-less as specialists left their traditional "posts" and "market-makers & liquidity providers" came on

the money isn't made "from nothing" it is made from the spread!

so, on a micro-level, the ability to move the spread with hi-freq agility became a cash cow and we saw mo&moCowbell

and the ability to "attack & beat the spread" [use it to your own trading advantage]  became a nano-science as the algo-writers studied the market makers and liquidity providers for HFT weaknesses

the central issue (again, just my opinion) is the "orderly market" rubric, which is why the specialists left in the first place:  they could not "fade" the M&A craze profitably and the costs/risks of maintaining "order among thieves" grew with every credit-bubble the banksters generated to buy assets [think GE under walsh, the LTCM blow-up, and the subsequent repeal of glass/steag. & the creation of thye TBTFs by TPTB, by which they took over america, politically and (mittens OR Prez0) surely intend to keep it]

the fascistas will get their peons to work on the boilerplate and "fix" things.  again

so perhaps people will begin to see the baseline fallacy:  that boilerplate can "fix" things

it can't;  slewienomics indicates it is always just:

boilerplate hubrisn-1 + MSM propaganda = "fixed!  trust us!"

and yes, it is global & globalism and it rules by moving the goal posts by boilerplate "legislation & regulatory powers"

btw, lauren was just up in vancouver and she published a buncha vids working w/ agoraPublishing (bonner& wiggins)

boilerplate determines the "power of the files" (maxWeber);  read what they send you for your bank acct, brokerage, options/ index options trading ok, even your phone and utility bills or your lease or rental agreement

that is boilerplate;  it is what the smiling attractive friendly marketing rep gives you for your money

it is free-market capitalism, socialism, communism, the US and the EU and canada and the WT0, the UN and the cable company too;  airline maintenance and teamster rest for drivers who would rather just push for home;  it is republicanism and democratism and teaPartyism---they all want to control the fuking boilerplate with their "marketing"

oil drilling, fracking and pielines;  additives and the superFund for clean-up too;   obamaCare& dodd/frank

then we all pretend TPTB understand and we watch TV for clues they have intelligence or pray that our religous leadership can guide us, too, into trusting the pols b/c that would be "god's will" b/c they are "in authority" and "enforce the boilerplate" even in pre-schools

HFT is merely a form of boilerplateHouseRules

go back and re-read the comments substituting "boilerplate" where appropriate...   see ya, BiCheZ!

Sun, 08/12/2012 - 11:18 | 2698704 resurger
resurger's picture

LAyren <3

Sun, 08/12/2012 - 11:31 | 2698721 QuietCorday
QuietCorday's picture

Interesting echo: in the film Limitless, about a man called Eddie Mora who becomes a ubermensch through taking a drug that gives him 100 percent access to all his brain power, Eddie appears to makes his fortune through inventing a process/mechanism somewhat like HFT. If you listen to the dialogue in the scene with him and Van Loon (De Niro), there is some mention of microscopic market processes that shave out pennies through tiny stock fluctuations.

I think this is kinda interesting as the film ties a thread from HFT antics to Master of the Universe-dom to political power to a state of almost human divinity. Makes me wonder if that film gives a reasonable representation of how the Squids actually think and see the world.

Sun, 08/12/2012 - 11:55 | 2698748 pd45
pd45's picture

In the movie, have you knoticed De Niro's chracter looks like Jamie Dimond?

 

Sun, 08/12/2012 - 14:13 | 2698936 knukles
knukles's picture

Except DiNero has a big penis

Sun, 08/12/2012 - 11:34 | 2698726 Everyman
Everyman's picture

Operationally, HF traders collectively send millions of orders, the most part of which (we understand above 90%) are cancelled before they are even hit.

 

So it TOTALY is illegal.  You cannot put in a bid that you have no intention of making.  That is called market manipulation, and the SEC should therefore shut down HFT just on that basis alone, regardless of the "benefits" or "negative effects".  You simply cannot "do" this in a market, it is not within the rules.

Every other argument is irrelevant.

 

Sun, 08/12/2012 - 13:48 | 2698894 malikai
malikai's picture

How do you prove an HFT machine's intention?

Sun, 08/12/2012 - 15:23 | 2699048 Everyman
Everyman's picture

By the end result.  The needs no "intention", all that has to happen as is stated on this forum many times:

MAKE THEM TAKE THE BID AND NO "DO-OVERS", they are stuck with their buy and sell orders.  HFT's put in a bid, that bid is made, and a 2 second rule would be good as well.  Ther is NO reason onther than swindeling for the issue of trades of "milliseconds.

Anyone who argues otherwise is just idiotic and plain foolish.

Sun, 08/12/2012 - 17:51 | 2699335 cifo
cifo's picture

Why would it be illegal? If you have the cash, you can make any bid you want.

Mon, 08/13/2012 - 17:30 | 2702086 philosophers bone
philosophers bone's picture

Everyman, you are bang on.  Forget all other arguments about whether HFTs are good or bad.  I think they call this "spoofing" and the regulators go after normal traders for this.  Why not HFTs?  Or they could implement a rule that says the algos can't spoof.  They could do this tomorrow, but of course won't.  Can't jeopardize "liquidity", LOL.

Sun, 08/12/2012 - 11:41 | 2698732 virgilcaine
virgilcaine's picture

lauren is a bot herself.

Sun, 08/12/2012 - 12:02 | 2698755 Seize Mars
Seize Mars's picture

I'd hit that bid.

Sun, 08/12/2012 - 11:45 | 2698734 Quinvarius
Quinvarius's picture

Wall Street can pretend HFT alone is a money maker or that it is some awesome tool.  But it is neither.  It is a loser.  It only works in conjunction with some other sort of fraud or arbitage.  If everyone is using HFT, there is no arbitrage.  So unless you are in on the fraud, HFT is just a loser when you are straight trading with it. 

HFT blow ups have been common with flash crashes and smashes.  They build up huge positions pushing around illiquid issues and then they try to get out and "boom".  But until knight, they cancelled trades and let the HFTs off the hook.  Knight is an example of what HFT really does to people who try to use it without the buddy system.

As long as we no longer cancel algo trade mistakes, HFT populatity will die.  It will only be used by bigger firms as a loss leader pushing the market around to make their options trades go in the money.

Sun, 08/12/2012 - 11:45 | 2698735 Timmay
Timmay's picture

HFS. High Frequency Skimming.

Sun, 08/12/2012 - 11:48 | 2698738 JohnKozac
JohnKozac's picture

"High Frequency House Flipping" is what 'High Frequency Trading' reminds me of.  Both will end(ed) the same way.

Badly.

Sun, 08/12/2012 - 11:50 | 2698740 blindman
blindman's picture

why can't the algos do the market making?
.
Message To The Voting Cattle
http://www.informationclearinghouse.info/article32152.htm
.

Sun, 08/12/2012 - 11:50 | 2698741 tuttisaluti
tuttisaluti's picture

When it's illegal, why is nobody enforcing the law?

Sun, 08/12/2012 - 11:59 | 2698751 Abitdodgie
Abitdodgie's picture

It is only illegal for you or I , not them. Anyway there are no laws in America any more .

Sun, 08/12/2012 - 12:09 | 2698762 Nadaclue
Nadaclue's picture

You are partially correct and partially incorrect.

The application of the Rule of Law is inversely proportional to the wealth of the individual be it monetary or political wealth.

The less wealthy one is, the more restrictive the RoL and vice-versa.

Sun, 08/12/2012 - 16:41 | 2699202 css1971
css1971's picture

Privilige literally means private law.

Sun, 08/12/2012 - 11:53 | 2698747 Cassandra Syndrome
Cassandra Syndrome's picture

Indeed. Mises masterpiece Human Action, quickly dismisses retrospectively any notion that the price discovery of Skynet is somehow a fine paradigm of the spontaneous order of dynamic markets.

Critics of the Austrian Perspective of the Economic Calculation problem, cite information technology as the new source of evaluating scarcity by quantity and providing the means of centrally planning resource alllocation. However no IT system no matter how advanced could possibly deal with desirability of humans and the subjective theory of value. As individuals we have subjective preference scales with infinite combinations collectively, which can never be derived except through the mechanisms of the market place where we all participate.

Sun, 08/12/2012 - 11:59 | 2698752 Goatboy
Goatboy's picture

Why call them Austrians? Why not simply and honestly Luddites?

Problem is not in HFT, its just a set of technical routines which are currently available. Why it is used as it is? Answer to that goes beyond very selective Austrian criticism. You cannot have your cake and eat it too. Its civilizational insanity to which Calimero Austrians are blind.

Sun, 08/12/2012 - 12:39 | 2698795 Cassandra Syndrome
Cassandra Syndrome's picture

Luddites were against Capital Investment. Savings and Investings are paramount fundamentals in Austrian Economics. Better and faster capital goods are the integral force behind advancement in civilisation. But these machines do not replace the market mechanism, they simply increase the standard of living.

HFTs are trying to replicate price discovery which can only be performed by humans. HFTs are just another form of bureaucratic central planning that crippled communist and socilaist nations for the past century.

 

Sun, 08/12/2012 - 12:01 | 2698753 Seize Mars
Seize Mars's picture

Well I think the article is technically correct, but then no one can blame me for running away from the market, right? I mean it's definitey not where I want my hard earned samoleons.

I think Ann Barnhardt is right when she says that the true fix to all this will be to revert to true open outcry once again. It's the only way...

Sun, 08/12/2012 - 15:06 | 2698992 slewie the pi-rat
slewie the pi-rat's picture

annB gets it imo

she understands that to have human fiduciary responsibility is to have human markets

and you get it too b/c at the same time, rules will never be so perfect "that humans no longer hafta be good" so the lack of enforcement actually now rules finance;   flee!  flee!

however the idea that "debt is money" and fiat-creating banksters and their fascista minions have "first crack w/ the new digits" tend to push the "responsible fiduciary" envelope into a rope-a-dope of MOPE where we hope the slope don't toboggan past our screaming ability to cope w/out a borgia pope may be the "base fallacy"

which is why i fight for PMs becoming re-established as legal tender (alongside fiat for now) so the public interface and tax-consequences of human economics are no longer determined solely by fiat banksters preaching "democracy and freedom for our valued debt-slaves" from the temples0'Doom while they subjugate every other form of human individual and collective enterprise to d.e.b.t.INC and bar the exits from d.e.b.t., politically/legally via boilerPlateHouseRules a.k.a. "legal tender laws"

fuking bullshit on a stick won't do this year... let's use waffle cones!

Sun, 08/12/2012 - 12:09 | 2698763 Troy Ounce
Troy Ounce's picture

 

Historically America is a country of swindlers and hustlers.

HFT, precious metal price suppression, selling wortless investments as AAA graded on a massive scale, regulator neutering are just some examples but explain eveything.

With the DOJ, regulators and Government looking the other way makes it failed state.

Do NOT follow this link or you will be banned from the site!