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Jodi Beggs

Some Evidence on the Liquidity Impact of High-Frequency Trading...

By December 16, 2012

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The common arguments in defense of high-frequency traders are that they provide liquidity to markets and that they aid in price discovery. Unfortunately, these claims are usually made based on intuition and without specific evidence to back them up. Luckily, we're starting to see empirical research on the subject, and the conclusions are not always in line with the intuition:

In fact, the authors find that "some HFTs are almost 100% liquidity takers, and these firms trade the most and are the most profitable."

It appears that the net effect on liquidity of the most aggressive traders is negative even under routine market conditions. Furthermore, even normally passive firms can become liquidity takers under stressed conditions when liquidity is most needed but in vanishing supply.

As far as price discovery is concerned, high frequency trading is based on a strategy of information extraction from market data. This can speed up the response to changes in fundamental information, and maintain price consistency across related assets. But the heavy lifting as far as price discovery is concerned is done by those who feed information to the market about the earnings potential of publicly traded companies. This kind of research cannot (yet) be done algorithmically.

I have a feeling this paper is going to get a lot of cites in policy discussions.

Comments

December 17, 2012 at 5:40 pm
(1) Bo Saunders says:

As Ross Perot used to say, “the devil is in the details.” Although I don’t believe the liquidity is justification for the existential risk associated with high frequency trading, I would have to see the methodology of the study to determine its relationship to my prejudices.

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