A recent working paper from the Bank of England reports on efforts to understand the rise of high-frequency trading and its impact on equity markets. I think it fair to say that the study fails to get any firm grasp of its subject matter, going “about it and about but evermore,” as poet Omar Khayyam wrote. The authors leave the subject by the same ambivalent door they used on the way in. Nonetheless, the trip is instructional, if only of the difficulties inherent in the subject matter.
The authors – Evangelos Benos and Satchit Sagade – distinguish between aggressive HFTs (which take liquidity from the marketplace) and passive HFTs (which serve a market making function, providing liquidity). The aggressive HFTs as so defined are the more controversial figures in the HFT world, so one of Benos and Sagade’s concerns is to determine the difference that this difference makes.
From Liquidity to Volatility
It appears that the aggressive HFTs have a larger impact than do the passive. One could rather hastily interpret this to mean that the aggressive HFTs make more of a contribution to price discovery than the passive HFTs. Aha! Then they are serving a function, and their price- discovery value justifies the liquidity they soak up. But wait ….
That inference would be too hasty because as Benos and Sagade also tell us, the larger contribution of the aggressives “is roughly proportional to their larger aggressively executed trading volume,” so that on a trade-by-trade basis, they aren’t really more informative than are the market makers after all.
There is no firm conclusion to be drawn from studying liquidity, so, let’s talk about volatility. Here, too, the authors start with a distinction. There is “good” volatility and there is “excessive” volatility (respectively, information and noise). They ask what HFT does to both.
A given trader can of course contribute to both. For example, the authors say, half of a particular party’s trades might be informed speculation (contributing to the information value of prices) while the other half are simply “used to calibrate her inventory levels,” adding to the level of noise.