Information technology has lowered barriers for creating/operating financial asset exchanges (venues for matching supply and demand). Proliferation of low-cost venues elevates competition for investor dollars and tends to depress transaction fees. Automated, broadened supply/demand matching tends to depress bid-ask spreads. This evolving market ecology attracts high-frequency traders (HFT), enabled by new technology to exploit short-term market predictability. Do such traders succeed, and how do they impact the markets in which they trade? In his December 2010 preliminary paper entitled “High Frequency Trading and The New-Market Makers”, Albert Menkveld examines the behavior of one large high-frequency trader (HFT) and the effects of associated trading on the exchanges in which this HFT participates. Using high-frequency (one-second) quote and trade data from two European exchanges during January 1, 2007 through June 17, 2008, he finds that:
- The arrival of the HFT coincides with a 20-30% drop in the bid-ask spreads of traded securities.
- On average, the HFT trades 1397 times per day per stock, with trading concentrated in large-capitalization stocks. The HFT avoids large positions and overnight positions, especially in small-capitalization stocks. The HFT does not seek market neutrality across positions, but appears to analyze stock-by-stock independently.
- The HFT is essentially a liquidity provider, earning a profit on the bid-ask spread net of fees that more than offsets losses to price trends. Profitability is much higher for large-capitalization stocks. Losses to price trends tend to increase with trade duration.
- Based on estimates of capital requirements, the HFT generates a very high annualized Sharpe ratio of 9.35 net of fees (but not net of algorithm development and other fixed operating costs).
In summary, the high-frequency trader profiled in this study appears to trade successfully on technical liquidity data, and not on price trend indications, mostly in large-capitalization stocks.
Potential implications for investors are:
- The HFT’s profits come at the expense of other traders. In other words, the HFT is a tough trading adversary.
- Trading frictions may continue to deflate, especially for large-capitalization stocks.
- To the extent that liquidity anomalies exploited by the HFT reflect other fundamental and technical information about stocks, market incorporation of and adaptation to new information may be accelerating, especially for large-capitalization stocks. Return anomalies may therefore be shrinking in duration and magnitude, with the best opportunities for individual investors perhaps increasingly concentrated in small-capitalization stocks.
- Withdrawal of HFTs from trading (especially when synchronized by unusual market conditions) may substantially remove market liquidity, resulting in positive volatility feedback.
Other HFTs may trade differently from the one studied. There may be return anomalies not materially subsumed by liquidity anomalies.
