Flash Boys Help Markets, Not Just Themselves, BOE Study FindsJohn Detrixhe
A year after Michael Lewis’s book brought the supposed menace of high-frequency trading to public attention, researchers at the Old Lady of Threadneedle Street suggest speedy trading may not be so bad for markets after all.
Electronic trading makes stock markets more efficient by enabling them to react more quickly to new information, the Bank of England working paper concluded. The authors took the FTSE 100 Index’s 20 largest stocks and examined how they traded on the London Stock Exchange in the four months through the end of 2012. They compared the trades of 10 HFT firms with the orders placed by 10 investment banks.
The report came out on the same day that HFT firm Virtu Financial Inc. published filings for a possible public offering later this year. Virtu suspended its share sale in the aftermath of “Flash Boys” as the book intensified concern that computerized trading firms had rigged equity markets. The company’s willingness to return to the market implies that investors and regulators increasingly accept HFT as part of market structure.
“Overall, I think it’s a good thing for the market,” said Michael Horan, the head of trading at Pershing, a unit of Bank of New York Mellon Corp. “Spreads have tightened and there’s empirical evidence to support that.”
A spread is the gap between the bid and offer prices for an asset. HFT firms may narrow the spread, making it cheaper to buy and sell securities, by updating prices more quickly with the latest available information.
High-speed traders place huge numbers of the same bets at the same time, prompting concern that their trading could cause or worsen sudden market crashes, according to the BoE analysis by Evangelos Benos, James Brugler, Erik Hjalmarsson and Filip Zikes. One possibility is that lightning-fast trading could lead to unpredictable interactions, which could mean prices become separated from measures of a company’s financial health, such as its profit and sales.
The BoE’s analysis didn’t support this worry. Instead of temporarily moving prices, simultaneous trading by electronic firms -- at least for large, individual stocks -- appears to cause relatively lasting adjustments, the authors wrote. Automated trading had a more lasting impact on prices than the activities of investment banks, which the researchers used as a proxy for the rest of the market, suggesting the computerized firms based their transactions on information about companies.
“If the trade had no information content, its price impact would be temporary,” the bank said in the working paper. “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.”
Lewis’s book portrayed the stock market as unfair because high-frequency traders could use more powerful computers and faster networks to take advantage of everyone else. Warren Buffett, the world’s second-richest person, has also criticized firms that can trade in fractions of a second.
The Bank of England study found the big HFT firms had a benign role, at least in terms of helping markets price stocks.
“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 research doesn’t prove that HFTs never induce or exacerbate market turmoil. “To assess that, additional research with more data, covering periods of market stress, would be necessary,” they said.
Controversial and Profitable
While automated trading may remain controversial, it is certainly profitable. Virtu made money every day in 2014, generating profit of $190 million from revenue of $723 million, according to the Feb. 20 regulatory filing for its initial public offering. The 148-employee company uses computerized strategies to buy and sell everything from stocks to currencies. It has only lost money on one day in the last six years.
New York-based Virtu’s larger HFT competitors include Tower Research Capital LLC, Global Trading Systems LLC and Hudson River Trading LLC.