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High Frequency Trading - Impact on Other Market Participants

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Without a doubt the global market structure has changed dramatically over the last decade. While many of our colleagues can remember the days of pit trading within the major stock exchanges, we now live in a world largely driven by computers. Using algorithms created by in-house computer programmers, many investment management firms, hedge funds, and professional traders are using computers to help shave milliseconds off of their trade executions.

With this advancement in technology and market structure has come increased attention from investors, regulators, and of course academics. Although high frequency trading is still a somewhat new development, research papers have already been published on its impact on price formation, market efficiency, and transaction costs. We recently came across a research paper authored by Jennifer Conrad, Sunil Wahal, and Jin Xiang that attempted to examine high frequency’s impact on the behavior of stock prices.

The authors looked at the entire U.S. stock market from 2009-2011 as well as the largest 300 stocks on the Tokyo Stock Exchange from 2010-2011 and wanted to see how high-frequency trading affected the quality of the market. Market quality is essentially the ability to have a consistent and fair price formation as well as provide liquidity during times of market stress. Bid-ask spread, transaction costs, and quotation updates are all part in determining the quality of the overall market.

The authors concluded that on average higher quotation activity resulted in lower transaction cost and prices that closely resembled a random walk, which is something that we would expect in an efficient market. What would not be beneficial is if high-frequency traders created a price formation pattern that followed some sort of short-term pattern (serial correlation), either positive or negative. Further, during periods of large drawdowns where it may seem reasonable to believe that high-frequency trading algorithms become the major contributor to such events like the “flash crash” on May 6, 2010, their research indicates the contrary. Price formation, even during periods of large drawdowns followed a random walk for high-frequency traders.

It is no secret that high-frequency trading brings both positives and negatives to the marketplace. Let’s first start with the negative. Michael Lewis highlighted the high-frequency traders’ ability to “front-run” the market in his book Flash Boys: A Wall Street Revolt. As a quick reminder, front running occurs when someone has advance knowledge of a large trade that is about to hit the market and profits by trading ahead of that trade. For example, if a broker knows that his high net worth client wants to buy 100,000 shares of Apple, then the broker could buy a few thousand shares for himself before placing the client’s order, and after the client’s order has moved the price up, the broker would sell his few thousand shares and pocket a tidy profit. We have written articles on this topic before. You can find a couple of examples here and here.

Now the positive. Although high-frequency traders may be earning small-profits based off speedy trade execution, they are providing a valuable service for other market participants in terms of lower transaction costs and liquidity. Bid-ask spreads for the largest companies in the world are close to a penny and no longer do we live in the world where specialists earn $0.13 on the dollar for every trade placed. While profits may be going into the pockets of high-frequency traders, those benefits are extending out to other market participants.

What does this mean for market participants, and more importantly, clients at Index Fund Advisors? The participants who are going to get hurt the most are those who trade frequently and in small amounts. We have discussed before why day trading is extremely hazardous to someone’s total portfolio and are definitely the biggest victims of high frequency traders. On the complete opposite end of the spectrum we have investors such as those at Index Fund Advisors who trade minimally and when doing so, do it slowly. Dimensional Fund Advisors (DFA) has revolutionized the way portfolio managers have approached not only indexing, but also implementation. With their patient and flexible trading approach, they have become a liquidity provider for other active traders and managers who are looking for immediacy in their trades. In essence, DFA has stacked the cards in their favor to dictate the price in the transaction, which is always a benefit.

So what is our recommendation? Do not take on the machines in any sort of day-trading effort. You will more than likely be taken advantage of by somebody or some thing that is much faster than you. If you are a client of IFA, just know that you are not a victim of high-frequency trading. Your investment partners (DFA and IFA) are well aware of the frictions that exist in the marketplace and they do their very best to not only mitigate them, but actually turn them into your favor. In terms of the entire market structure as a whole, there is no conclusive evidence that high-frequency traders disrupt the overall price formation process or liquidity in the marketplace, even during times of market distress. While many computer algorithms may go off at the same time to either sell or buy a particular security or group of securities, there are liquidity providers with a long term investment focus, like DFA, to reap the benefits of the opportunity.