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March 1, 2014

A Clear Answer on HFT

High-frequency traders and supporters claim that HFT is helpful to the equity market. The data presents a starkly different story.

By Tim Quast

With a horizon of less than a day, HFT isn't investment but arbitrage. While trading that corrects temporary value-distortion offers benefits, it shouldn't be a top price-setter. We use models to identify behaviors setting price every day in individual securities. In a mega cap, a household-name consumer-goods company, HFT was more than eight times more likely to set price in the five trading days ending Dec. 6 than was fundamental investment. Looking 20 days back, HFT was almost 20 times the price-setter of any other behavior.

It's not unique to mega caps. In the same period, HFT was again eight times more likely to set the price in a particular Nasdaq-traded small-cap biotechnology firm over five trading days, and over 11 times more likely to set price in the trailing 20 trading days. When intermediaries are vastly superior as price-setting forces to either bottom-up or top-down investment, they are distorting prices and disrupting natural function.

It doesn't end there. Often, HFT reacts violently to change in underlying algorithmic order-flow. Reactions are routinely measurable in models a day before, serving as a reliable harbinger in our analytics of impending adjustment to price-direction.

Contrary to popular belief that HFT reduces volatility, data demonstrate the opposite. A financial-services firm reported results on Dec. 10. On Dec. 11, the stock had intraday volatility-spread between high and low prices-of 9 percent. HFT was 30 times more potent as price-setter than bottom-up investment, the behavior a distant second in setting price. Bottom-up investors were pleased with results, price-setting data indicated. Yet HFT, with fractional liquidity-just 1.4 percent of total-dominated price-setting and fostered massive volatility, pushing closing price down and offering an impression to market participants of something other than the truth. It happened because indexes and ETFs, normally potent price-setters, declined on Dec. 11. In the vacuum, fast traders rapidly repriced the market to encourage action on fear or greed.

While HFT accounts for more than 60 percent of all volume (we measure not just proprietary trading but riskless-principal market making by large two-sided brokers), it's but a few percentage points of liquidity at most, and in this instance not even 2 percent of it. By brutally varying the availability of that liquidity, HFT distorts market supply and demand.

This should be no surprise. HFT firms are in effect shill bidders wanting to risk and own nothing but to profit on others' interest in things. They are the first to disappear when value vacuums form in markets.

Rules shouldn't promote it at the expense of capital formation. The stock market exists to facilitate capital formation, pooling investment capital for commitment to growth and value enterprises over time. The laws even require that capital formation be a priority.

Those who contend there's no evidence structure is damaging capital formation aren't tallying public companies. Through the history of the modern stock market in the United States, the trend line in traded issues has been steadily up as new enterprises outpaced consolidation. But since the order-handling rules took effect in 1997, which promoted price-and therefore arbitrage-to king of value in equities, the number of public companies has fallen precipitously. In 1998, there were nearly 8,000 issues in the Wilshire 5000, and today there are fewer than 3,600.

The equity market's volume reflects movement, not investment. Intermediaries dominate price-setting, clouding perceptions of what sets prices and whether supply and demand are balanced. The result is relentless shrinkage in the product of capital formation: public companies.


Tim Quast is president of equity data-analytics firm Modern Networks IR.

The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to

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