No profit, no liquidity

February 20, 2014 07:08 PM

A recent Bloomberg story highlighted how University of Chicago Professor Eric Budish is proposing a new electronic trading market structure for equities and derivatives. Budish notes in a paper published in December that,  “the continuous limit order book is a flawed market design and [we] propose that financial exchanges instead use frequent batch auctions: uniform-price sealed-bid double auctions conducted at frequent but discrete time intervals, e.g., every 1 second.”

 Budish presented his idea to the Commodity Futures Trading Commission at a recent meeting of its technology advisory committee.

While at one point in the paper the authors state that they want to get away from the debate over whether high frequency trading is good or evil, the underlying theme is that HFT is damaging the markets and given the following; "frequent batch auctions lead to narrower spreads, deeper markets, and increased social welfare," it seems pretty clear where they come down on it. 

The Bloomberg story states, “The academic says it would preserve the useful function that high-frequency traders provide -- generating liquidity -- while eliminating their ability to take advantage of momentary mispricings and profit through pure speed.”

That would be a nice trick. 

I hate to question a University of Chicago professor (and have not gone through the entire paper) but have to point out the obvious, which is the fact that the ability to take advantage of momentary mispricings and profit from it is why high frequency traders do what they do and I don’t see high frequency traders providing the useful function of generating liquidity without a profit motive.

The paper states, “First, we use millisecond-level direct-feed data from exchanges to show that the continuous limit order book market design does not really “work” in continuous time: market correlations completely break down at high-frequency time horizons. Second, we show that this correlation breakdown creates frequent technical arbitrage opportunities, available to whomever is fastest, which in turn creates an arms race to exploit such opportunities.”

This has always been the case and I would be very cautious of changing a system that has worked pretty well for many years.  Every trader on the floor attempted to gain an edge, I don’t see how that has changed in this electronic world; only the means to achieve it. The most important thing is that speed advantages are transparent and available to anyone willing to invest in the infrastructure.

It goes on to say, “we show that frequent batch auctions eliminate the arms race, both because they reduce the value of tiny speed advantages and because they transform competition on speed into competition on price.”

The line “reduce the value of tiny speed advantages” is troubling as, once again, by doing this it would reduce the motivation for certain entities to enter the market and thus reduce liquidity.

I would welcome a more scientific analysis of this proposal but from the face of it, it seems to ignore some pretty obvious realities of why traders trade.  



About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.