In trying to examine the background and underlying causes of financial market events such as the disruption in equity trading on August 1, or the “flash crash” of May 6, 2010, the question of whether we are looking at some fundamental change in the way the markets work is frequently raised. Trading volumes have certainly increased over the past few years, but firms engaged in high-frequency trading tend to be rather reticent about the exact nature and extent of their operations.
In one of my posts about the 2010 flash crash, I mentioned an analysis carried out by Nanex, a firm that specializes in systems and software to distribute and process market data, giving them a particularly good view of the overall market.
Our business is supplying a real-time data feed comprising trade and quote data for all US equity, option, and futures exchanges.
I have just come across a rather striking demonstration, put together by Nanex, of the growth of high-frequency trading (HFT) activity in US markets over the period January 2007 through January 2012. The top graph on the page is an animated GIF graphic, which shows daily HFT activity for the various US exchanges (denoted by different colors). At the beginning of the period, in 2007, the lines are relatively flat. As time progresses, one begins to see more activity, first at the beginning and end of the trading day, then spreading throughout the day. Assuming Nanex’s data are correct (and I have no reason to doubt that), there has been a very substantial increase in HFT activity over the last few years.
The graphs on the lower part of the page show a more interesting aspect of this growth. The graph on the left shows the growth, over time, of quote activity (that is, the posting of bid and offer prices for securities). The graph on the right shows actual trades over the same period, It is clear that most of the activity growth is in quotes, rather than trades. There was some suspicion, in the 2010 flash crash, that some market participants might have engaged in “quote stuffing”, the generation of spurious quotes that would effectively clog up competitors’ systems. There is certainly nothing in this evidence to disprove that suspicion.
Nanex also points out that spurious quote messages, like spam, are close to free for the sender, but not for other market participants. As noted above, the large increase in quote activity does not correspond to an increase in actual trades, meaning that the cost per trade of processing quote messages has gone up substantially.
We think that a 10-fold increase in costs without any benefits would be considered “detrimental” by most business people. We think the regulators would agree with us as well.
This analysis, together with other evidence, suggests that HFT activity is not as benign as some proponents would have us believe. As Prof. Ed Felten at Princeton observed back in 2010, it can be difficult to disentangle just what happened after the fact, but I’ll try to fit some of the pieces together in future posts.