New Bank of England study finds high frequency trading to have positive effect on markets

Photo courtesy of Ars Electronica on Flickr

Photo courtesy of Ars Electronica on Flickr

Rob Swystun, Pristine Advisers

High frequency trading (HFT) has received a lot of flak since its inception. With untold numbers of trades being able to take place in the blink of an eye, one could see how it would be perceived as a little worrisome.

But, now a new study by the Bank of England (or the Old Lady of Threadneedle Street, as I’ve just recently learned those crazy Brits call it) suggests that this fast-paced trading might actually be good for markets despite all the negativity that it has garnered — much of which was included in Michael Lewis’s book Flash Boys.

The book claimed that high frequency traders used more powerful computers and faster networks to take advantage of other market players and it had a detrimental affect on the market.

But, as reported by John Detrixhe in an article for Bloomberg, the working paper by the Bank of England concluded that high frequency trading makes stock markets more efficient because it enables them to react much more quickly to new information.

To conduct the study, the bank examined how the 20 largest stocks on the FTSE 100 Index traded in the last four months of 2012. The report authors compared the trades of 10 HFT firms with orders placed by 10 investment banks.

With their ability to make huge numbers of transactions simultaneously, HFT has prompted concerns that these transactions could cause sudden market crashes or worsen a market crash that has already happened, report authors Evangelos Benos, James Brugler, Erik Hjalmarsson and Filip Zikes say. They point out that lightspeed trading may lead to unpredictable transactions, separating prices from measures of a company’s actual financial health like sales and profit.

However, rather than the temporary shifts in prices that many were worried about, for large, individual stocks at least, the Bank of England’s analysis found that HFT tends to cause relatively lasting adjustments. In fact, the report authors found that automated trading had even more of a lasting impact on prices than those of the investment banks, which the report authors used as a general representation for the rest of the market. This suggests that these high frequency trades are being based on information about the companies.

“If the trade had no information content, its price impact would be temporary,” the report authors wrote. “The induced price change would not be justified by any changes in fundamentals and market participants would force the price back to its original value.”

The study found the HFT firms used in the study had a benign role in the market, at least in terms of stock prices.

“HFT firms appear to be reacting simultaneously and quickly to new information as it arrives at the marketplace, which makes prices more efficient,” the researchers wrote. “This suggests that correlated trading by HFT firms does not appear to contribute to undue price pressure and price dislocations on a systematic basis in the U.K. equity market.”

The researchers did warn that their research doesn’t prove that HFTs never induce or exacerbate market turmoil, though. “To assess that, additional research with more data, covering periods of market stress, would be necessary,” they wrote.

HFT does have its fans.

“Overall, I think it’s a good thing for the market,” Michael Horan, head of trading at Pershing, a unit of Bank of New York Mellon Corp, said. “Spreads have tightened and there’s empirical evidence to support that.”

HFT helps narrow spreads — the gap between the bid and offer prices for an asset — by updating prices more rapidly with the latest available information, which makes it cheaper to buy and sell securities.

Despite the controversy, HFT is going strong and making those involved with it buckets of money.

According to the Feb. 20 regulatory filing for its initial public, HFT firm Virtu made money every day in 2014, generating a profit of $190 million from revenue of $723 million. Based in New York, it uses computerized strategies to buy and sell stocks and more and it has lost money on just one single day in the last six years.

Does HFT deserve its rep as a much maligned menace or can it boast benign business, bypassing belligerence? What do you think?

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