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April 1, 2010

Cameron Smith on HFT

By Editorial Staff

Cameron Smith is general counsel for high-frequency trading firm Quantlab Financial. He has taken a leading role in the debate over high frequency trading. Below are excerpts from his recent treatise defending high-frequency trading.


On trading costs--

Investors have reaped the benefits of the SEC reforms that led to the rise of high-frequency traders and electronic markets. The most obvious direct benefits to investors are reflected in the dramatic reductions in trading costs and spreads over the past 10 years.


On volume--

One benefit to investors is the dramatic increase in trading volume, which makes it easier for investors to cheaply buy and sell securities. Some critics contend that the rise in trading volume and the substantial market share of high-frequency traders is evidence that the markets have become tools for speculation. But what these critics misunderstand is that professional traders have always been a large percentage of the volume. These intermediaries bridge the fluctuations between supply and demand that occur throughout the trading day. If only long-term investors were trading securities, there would not be adequate liquidity to keep markets stable and spreads narrow.


On trading alongside large orders--

A healthy market is supposed to reflect all known information about a stock, including supply and demand. The fact that an investor is buying a large number of shares obviously impacts demand and should trigger a rise in the stock price. The critics of high-frequency trading, however, are saying that the market should stop following the laws of supply and demand when they want to buy or sell so they can get a better price than they otherwise should. The logical conclusion of their claims is that, when market participants--including high-frequency traders--forecast a probable price change in a stock, they should nevertheless treat that information like one treats a young child during a game of hide-and-seek. Namely, these critics want everyone else to pretend that they don't detect a change in supply or demand even though they can see the figurative leg sticking out from behind the couch!


On volatility--

The volatility-reducing effect of high-frequency trading was highlighted during the recent ban on short selling. When all short sales in financial stocks were suddenly banned, high-frequency traders either reduced or stopped trading the impacted financial stocks. The result? A substantial increase in volatility and spreads, increasing trading costs for all investors.

Cameron Smith, Quantlab Financial


On studies of HFT behavior--

The few studies that are based on data sets that enable a detailed analysis of high-frequency trading activity found that high-frequency traders actually lowered short-term volatility, and that high-frequency traders were more likely than the rest of the market to push stock prices towards fair value.


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