The Problem With HFT Explained In One Chart

For all the sudden fury at HFT in the aftermath of the Michael Lewis 60 Minutes interview which merely served to underscore Goldman's dramatic U-turn on all things market structure-y, the reality is that, as we have explained over the years, high frequency strategies are not all bad and not all are the latency arbitrage, momentum ignition, liquidity detection-type predators and parasites we have repeatedly shone the spotlight on years before anyone else paid attention.

Indeed, as Blackrock points out in its just released paper "US Equity Market Structure: An Investor Perspective" there are more constructive HFT strategies, mostly dealing with pure play liquidity-providing rebate collection, and there are the "less constructive" ones - or all those that in one way or another end up hurting someone else, be it the retail or institutional investor.

And just as there is a scale of "usefulness" of HFT strats, so there is a gradient of strategy profitability to HFT operators.

In the chart below we have shown Blackrock's original chart, to which we added the shaded box indicating the shift from least profitable strategies, those that also happen to be the most constructive if least rewarding, to the most profitable ones, obviously the ones that are "least constructive."

The problem then becomes readily apparent: without any gates to prevent HFT (ab)users from positioning themselves anywhere they wish in the constructiveness/profitabilty spectrum, it goes without saying that everyone will immediately flock to the most profitable, and hence, least constructive and most predatory, HFT strategies.

It also means that while in theory HFTs can and should provide liquidity, they rarely if ever do as most of them are far more focused on such high IRR activities as latency arbitrage, flash orders, momentum ignition, liquidity detection and headline trading - none of which validate the main claim of HFT proponents: that they provide liquidity.

It is this conflict that has to be addressed by the clueless, coopted and complicit regulator that is the SEC if there can be any hope that the retail investor will ever regain some sense of fairness about what right now, is certainly an "abnormally" rigged market (as opposed to the normally rigged, which as all insiders know, it is most of the time).

The HFT problem in a nutshell below.


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