If HFT GUARANTEES profits, why are the profits to HFTs declining so sharply, and why do HFT firms make such a small fraction of what the buy-side firms make?
Much more discussion here:
Much more discussion here:
The key results in this paper are that:
- market correlations 'predictably' break down at high-frequency horizons
- these correlation breakdowns create a winner-takes-all speed arms race to exploit these opportunities
- a theoretical model can be built to explain the investment in speed as a function of these opportunities
- this model reduces to the prisoner's dilemma from game theory
- the equilibrium state of this model is an environment higher spreads and thinner markets than is socially optimal (without the arms race).
It's a very interesting and readable paper, peppered with interesting market observations and theoretical insights.
http://web.eecs.umich.edu/srg/wp-content/uploads/2013/02/ec3...
But in a study last year, University of Michigan professor Michael Wellman and I developed a model across two exchanges. We examined a strategy called latency arbitrage, which utilizes advantages in access and response time to exploit price disparities caused by fragmentation across those dozens of competing venues. HFTs employing latency arbitrage examine current market information to predict immediate price movements, essentially computing the best prices available before the exchange has even had a chance to update its price quote.
What we found may be even scarier than Lewis's book-selling punchline: it's not simply a matter of the HFT crowd taking profits away from regular investors. Predatory strategies like latency arbitrage have the potential to reduce trading gains for all market participants – high-frequency traders and Average Joes alike.
Their solution was to go to periodic call structure.
You don't mention it, but they actually recommend a centralized discrete call market. How is that to be implemented? They don't say and they don't count the additional added cost/risk of adding a centralized monopoly player into the market (in fact they completely ignore transaction fees). We moved away from centralized markets in the first place because those costs were non-trivial.
But IMHO the issue is not so much here understanding all of the -N- ways to regulate the problem. It's helpful in the first instance to have clear articulations of the problem you need to consider. Market micro-structure is like taxes. It's almost impossible to generalize an answer. An "actual answer" will entail a level of detail and laywers fees that is prohibitive to discuss "for fun" =D. We can apply this critique to all of these academic papers too: they are abstractions and model-markets. The actual particulars of any given order routing...etc.
So what is the purpose of this even being posted? It is simply to illustrate how sub-optimal outcomes are possible on a whiteboard. The general takeaway is there is a problem (worsening equilibrium) and a solution (improving one) that relate to tweeking the variables (timing/trade sequencing) discussed upthread. Those are not purely neutral or unrelated to welfare outcomes.
It helps to have someone else spell it out sometimes. Both to save the brain damage of spelling it out in HN comments, and also to provide some fresh voices to the dialogue.
virtu's prospectus as a case in point. https://www.sec.gov/Archives/edgar/data/1592386/000104746914...
That becomes more likely for any given firm as the competition increases. Spreads get smaller; there's more competition for any given trading opportunity. For each firm, that can mean declining profits per trade and declining numbers of trades made. When the product of those two numbers gets too low, you're in the red.
Worse, they ignored many alarms as the company was sinking.
This is not correct. Read the SEC report on the incident if you have time, it is pretty in depth: http://www.sec.gov/litigation/admin/2013/34-70694.pdf
The short-version is that they re-used a parameter from an old feature and one of the production machines was not updated so the re-used parameter re-activated the old feature instead of the new one. Furthermore, A refactoring of the code had left the old feature on the wrong side of the share accounting code so the system was not keeping track of the orders it was putting out.
But still it was not any kind of market or trading risk that blew them up--just a litany of control failures and bad code.
http://washpost.bloomberg.com/Story?docId=1376-N2CB0F6TTDTQ0...
edit: I did not imply that none of the hft strategies were taking market risk. The ones that scalp certainly seem to.
In the absence of "scalping", trading in stocks works like trading in houses. There are lots of buyers. There are lots of sellers. In the majority of cases, they disagree materially on the correct price. Therefore, it (a) takes forever to enter or exit a position, and (b) often forces people to accept terribly unfavorable pricing.
The "scalp" market makers take is the market price for always having a counterparty willing to trade with you at a price near the true market value of the trading instrument.
If you want the markets to work more like the real estate market, you can do that: place limit orders. The fact that market orders carry a premium price isn't a subtle detail of the market; it's trading 101.
All things being equal, you want the "scalp" to be as thin as possible. The wider the spread, the closer the scalping blade comes to the skull. Liquidity has a price, and investors want that price to be as low as possible.
So now, an exercise for you: at the height of HFT profit-taking, was the price of liquidity (a) lower or (b) higher than it was during the 1990s?
http://www.nytimes.com/2005/04/13/business/13nyse.html?pagew...
[Edit] I am referring to another firm; it seems if you are in the trading business, you are taking risk. This certainly has multiple meanings. You can measure risk against a position you hold relative to holding nothing. If you are a Market Maker HFT, then you risk the market collapsing out from under you when you are legally obligated to stay in.