Is high-frequency algorithmic trading (HFT) actually making markets more efficient, or is it simply pushing the smaller trader out of the markets?
This question has been a hot topic particularly since Michael Lewis' most recent book Flash Boys focused a spot light on high frequency trading and the potential rigging of the equity markets. While Mr. Lewis keyed mostly on the stock market inequalities, the same can be said about the futures markets. The root of the issue really comes down to the exchanges monetizing latency in order traffic.
In other words, the exchange will sell faster execution to the highest bidder which fairly obviously skews the playing field. This is somewhat tangential to the direct question above that is essentially asking whether the HFT firms unfair advantage does, in the end, provide value through liquidity in the price discovery of given markets. The question then becomes 'Is all volume equal?'. The exchanges will contend that all volume is equal in that more trades equals better liquidity. The fact that for every buyer there is seller would seem to indicate on the surface that more volume from these HFT firms would increase efficiency and liquidity.
However, in looking a little deeper, say for example that most of the volume from HFT firms was on the buy side when the market was rallying and that information was transmitted to those firms faster than to the smaller trader. The effect of that advantage is the smaller trader with the slower price feed ends up being in the way of this massive juggernaut of orders that are, once the small trader sees them, already through there price, thus producing an instant loss for the small trader and a virtually riskless gain for the HFT firm.
Further complicating the issue is the exchanges willingness to allow these algorithmic firms to create a litany of order types (there used to be four or five order types like stop, limit, market etc. and now there are somewhere nearer 100 different types). These different order types are particularly geared toward LESS transparency in the price discovery which, depending on how you define it, would seem to me to be the opposite of what one would want when describing a truly efficient marketplace.
As an industry participant for more than 20 years as a trader and broker I have had a bird’s eye view of the changes that have resulted from the HFT revolution. I can conclusively state with absolute conviction that the liquidity of the marketplace has been harmed dramatically by the inequalities in the market.
Furthermore, the 'market makers' that have traditionally been the back bone of price discovery are being driven out in droves with many of those once large liquidity providers now unable to perform this valued function. One only needs to look to the past view days for further evidence of this liquidity versus volume argument.
The Chicago Mercantile Exchange (NASDAQ:CME) has recorded record volumes that past several days with the radical swings the market has produced. That record volume did very little to provide actual liquidity as we saw normally very liquid markets like the S&P 500 (CME:ESZ14) futures and United States 30-year bonds price ranges go far further than they ever would have under similar circumstances prior to the HFT phenomenon (nearly 6 handle range in the bond market!!). The result was fairly obvious as we saw massive gaps in the pricing with what can only be termed as a slew of mini flash crashes that the average trader had zero price information on. The more conditions we see like these (and it has become more and more frequent, pun intended) will continue to lead to the mass exodus of the middle market maker thus drastically increasing the volatility of the market place and, in fact, reducing the markets efficiency.