What do you think of the big HFT study? It’s this big HFT study that CFTC chief economist Andrei Kirilenko conducted on S&P 500 e-mini futures at the CME, and it’s already inspired a metaphor from CFTC commissioner and all-purpose spinner of metaphors Bart Chilton:

Mr. Chilton said that the study would make it easier for regulators “to put forth regulations in a streamlined fashion. It’s a key step in the process and it should fuel-inject the regulatory effort going forward.”

Not his best effort, fine. Anyway, the study: I’m not sure I’ve earned the right to have an opinion, both because (1) that, generally, and (2) my model of high frequency traders as micro-mini-market-makers is a bit upended by the fact that the bulk of the HFTs in this study seem to be taking, rather than providing, liquidity.1 It’s possible that the e-mini market is not the best place to measure the overall effects of HFT, either for fundamental reasons (its use for hedging etc.) or more crassly because it lacks the liquidity rebates that drive a lot of HFT in other markets.

That said what I like about this study is that instead of measuring transaction costs in naive ways like “bid/ask spread,” it measures transaction costs in sensible ways like “in a series of zero-sum transactions, how much money do HFTs suck out in profits.” Though the measure of profitability is sort of kooky:

The profits calculated in Table 3 are the implied short-term profits: we calculate the marked-to-market profits of each trader on 1 minute frequencies2 and reset the inventory position of each trader to zero after each of these 1 minute intervals. Then, we sum up all the 1 minute interval profits to get a measure of daily profits. Therefore, we capture the short-term profits of traders and not gains and losses from longer-term holdings.

What this means is that if your model of market-making is “buy at 99.9, wait five minutes, and sell at 100.1,” then your profits might end up showing as 0.2 or -0.2 or zero or something else on that calculation.3 So regular old market making may look bad, while HFT market making – designed to move quickly – looks much better. And so you get this table:

This shows daily profits of each class of trader – active, mixed, and passive HFTs (defined by how often they take liquidity vs. providing it; active HFTs take liquidity >40% of the time); non-HFT market makers, large fundamental traders, small retail traders, and “opportunistic” traders, meaning those who don’t fall into any other category. And in fact non-HFT market making looks crummy, though not as bad as being a retail investor, which, obviously. Here is the same data by cost per (~$70,000 notional4) contract:

You could draw a couple of tentative conclusions from this, but here’s one from the paper:

Since Aggressive HFTs collect $2.04 per contract (Column 9, Row 2) over 15.2% of the volume (Table 1), while everyone else loses while trading 84.8% (=100% – 15.2%) of the volume, the effective Aggressive HFT imposed transaction cost on all other traders is $2.04*(0.152/0.848) = $0.36 per contract. Scaling this per-contract transaction cost by $50,000 the approximate price of a contract yields an estimated HFT-imposed transaction cost of 0.0007%.

Or you can take an upper bound which is the $5.05 per ($70,000) contract that retail traders apparently lose to passive high-frequency traders and conclude that HFT costs small investors as much as three-quarters of one basis point of returns.

Here’s the author’s comment:

Mr. Kirilenko warned that the smaller traders might leave the futures markets if their profits were drained away, opting instead to operate in less transparent markets where high-speed traders would not get in the way.

That seems extreme for less than a basis point! Especially when you consider that small traders lose money to everyone, and they lose more to non-HFT market makers (i.e., whoever would be selling to them in less transparent markets) than they do to active HFTs (i.e. the traders who make up the bulk of the transparent, HFT-infested markets).5 “Screw you guys, I’m going to my broker’s dark pool,” say the retail investors, and lose twice as much. Or something.

Anyway, the paper is worth reading. There’s good stuff on the consistency of HFT profits and what it says about how HFT firms make their money. But I wouldn’t count on it to fuel-inject efforts to shut down high frequency trading. This paper doesn’t seem to me to suggest that high frequency trading costs “regular” investors all that much, and it certainly doesn’t suggest that it costs them more than the alternative.

Matthew Baron, Jonathan Brogaard & Andrei Kirilenko: The Trading Profits of High Frequency Traders [NBER]
High-Speed Trades Hurt Investors, a Study Says [NYT]
High Frequency Trading Arms Race Has Plenty of Drawbacks [MarketBeat]

1. I am not, however, alone in being puzzled by that:

Those findings run counter to a frequent claim by high-frequency traders, or HFTs, that they are largely “passive” investors that provide rivers of liquidity to the market, helping regular investors move in and out of stocks more easily. Instead, the firms—at least those most profitable—appear to be sucking up vats of liquidity.
Mr. Kirilenko says the finding was among the most surprising of the study. “It is in direct conflict with the statement that HFTs are providers of liquidity,” he said in an interview.

2. Table 3 says 10-second intervals. It’s a draft.

3. As I read it. I find it a little puzzling but for instance if you buy at 10:00:05.00 at 99.9, and then at 10:01:00.00 the mark-to-market is 99.9, then you have zero profit (or if it’s 99.8 you have -0.1, etc.). If at 10:01:30.00 the price goes up to 100.0, you have no profit on this measure, because your inventory was reset to zero at 10:01:00.00, though in reality (1) your inventory is one contract and (2) you have a 0.1 actual profit. If you then sell out at 10:05:05.00 at 100.1, then this gives you a short position and you have to look at the price at 10:06:00.00 to see if you actually have a profit; if it’s back down to 99.9 you show a 0.2 loss. Even though your timing was actually impeccable.

4. The e-mini is $50 x the S&P 500 level, which makes it worth $70,000-ish now; the study is August 2010 – August 2012 so notional starts at around $55,000. The authors use a $50,000 approximate contract price.

5. Though they pay non-HFT market makers less than they do to passive HFTs. This is the most puzzling result of all to me, actually: that passive HFTs (that is, classic high-frequency market makers) make $5.05 a trade off of retail investors, while (1) classic non-HFT market makers make less and (2) passive HFTs lose $0.62 per trade to large fundamental investors. Everything there goes against my first intuitions:

  • HFT market makers should make less than non-HFT market makers off liquidity takers, since they should be faster and lower-cost and able to undercut non-HFT market makers.
  • HFT market makers should make less off retail than they do off fundamental investors, since they should offer price improvement to get small retail orders while backing away from large informed orders.

The answer may lie in measurement: the fundamental traders could just be better at buying contracts (at a wider bid/ask spread) and seeing their price rise in the one-minute interval that is measured in this paper. The authors say:

The empirical results support the first hypothesis that Fundamental (institutional) traders are generally informed traders able to evade leaving a detectable pattern in their trading activity from which HFTs glean information. The results also support the hypothesis that Small (retail) traders are noise traders who incur the largest effective transaction costs per contract.

36 comments (hidden to protect delicate sensibilities)
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Comments (36)

  1. Posted by Mercury | December 4, 2012 at 10:16 AM

    Markets fixed, everyone back in the pool. Welcome to the recovery.

  2. Posted by guest | December 4, 2012 at 10:20 AM

    Next year we will price in 10 cent increments, just for Goldman bonus sake……………Timmy G

  3. Posted by August Gorman | December 4, 2012 at 10:26 AM

    Matt, where were you when I needed you?

  4. Posted by PermaGuestII | December 4, 2012 at 10:31 AM

    Why are retail investors screwing around in the e-mini futures market to begin with?

  5. Posted by guest | December 4, 2012 at 10:34 AM

    ZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZ

  6. Posted by inlovewithpmco | December 4, 2012 at 10:41 AM

    bring back the soes bandits

  7. Posted by Guest | December 4, 2012 at 10:46 AM

    I really don't know how the Timberwolves expect to get anywhere this season with one of their best players getting mired down in the tedium of publishing a major economic study.

  8. Posted by nachocheese | December 4, 2012 at 10:53 AM

    looks like the dude does not get high frequency hair cuts

  9. Posted by HighFrequencyHater | December 4, 2012 at 11:12 AM

    "The excitement has drawn in fledgling stock buyers such as 11-year-old Jade Supple of Rockville Centre, N.Y., whose father plans to bet money saved to put his daughter through college on Facebook shares, although he has doubts about the price." http://online.wsj.com/article/SB10001424052702304

  10. Posted by Shecky Mikimoto | December 4, 2012 at 11:17 AM

    In the pearl market, many country and western stars like to invest in e-mini pearls.

  11. Posted by Baa Baa | December 4, 2012 at 11:19 AM

    You must have been counting your recent sexual conquests……

  12. Posted by Laxbro | December 4, 2012 at 11:20 AM

    I mean his flow lacks waves but I'd say D1 club level hang time.. dece lettuce overall IMO

  13. Posted by HighFrequencyHater | December 4, 2012 at 11:21 AM

    Summary of the study: The edge you earn by buying/selling at the best bid/ask approaches zero in very short time.

    Shocker; I thought everyone can become rich by just making at the top of book and waiting to hedge 5 minutes later.

  14. Posted by Kahhhhhhhhhhhhhhn! | December 4, 2012 at 11:28 AM

    They should put AK47 in charge of the CTFC if they wanted to crack down on illegal trading, just for nickname value alone!

  15. Posted by Kudos | December 4, 2012 at 11:33 AM

    Transcendently Awful

  16. Posted by Hobbes | December 4, 2012 at 11:33 AM

    I'd trust Bart with selling me some Ikea furniture, but not financial market regulation.

  17. Posted by Guest | December 4, 2012 at 11:46 AM

    Hey, Vigo the Carpathian, simmer down!

  18. Posted by Rikki Tikki Tavi | December 4, 2012 at 11:52 AM

    With such a short time interval, the profits from non-HFT MMs to fundamental traders is probably way overstated.

  19. Posted by Matt's Mom | December 4, 2012 at 11:56 AM

    Matt, all these early morning posts have me worried how you're staying up all night….

  20. Posted by Garrison Faber | December 4, 2012 at 12:00 PM

    Ha Ha! Andrei Kirilenko plays for the Timberwolves!

    -Minnesota guy that knows a thing or two

  21. Posted by Texashedge | December 4, 2012 at 12:21 PM

    "Instead, the firms—at least those most profitable—appear to be sucking up vats of liquidity.

    Mr. Kirilenko says the finding was among the most surprising of the study. “It is in direct conflict with the statement that HFTs are providers of liquidity,” he said in an interview."

    Not sure I understand how HFT firms that do lots of equal parts buying and selling would be 'sucking up liquidity' or really how 'sucking up liquidity' is even a thing (I mean, isn't 'sucking up liquidity' another way of saying 'providing liquidity'?)

  22. Posted by Guest | December 4, 2012 at 12:53 PM

    “The message in the metaphor is that we really are boarding, implementing that is, and ready for regulatory takeoff of Dodd-Frank. We’ve been waiting around the gate area, eating Cinnabons and watching cable news since July of 2010."

    - Bart Chilton

  23. Posted by Strong Sell | December 4, 2012 at 1:26 PM

    Ah, finally a Matt Levine post to serve as a natural sleep aid. Goodbye Ambien.

  24. Posted by Dumbass Oil Trader | December 4, 2012 at 2:04 PM

    Do what?

  25. Posted by Caption Contest | December 4, 2012 at 2:14 PM

    "Tiger told me it was *this* long"

    -Greg Norman

  26. Posted by Guest | December 4, 2012 at 3:17 PM

    It's not a matter of buying vs. selling. It's considered "providing liquidity" to place a a bid *or* offer which is posted in the market for some period of time before being filled. Whereas an order which hits the bid or offer when it's placed (market taking) is considered taking liquidity. The equity exchanges pay equal rebates whether you're on the bid or offer side, as long as your order spends some time t > 0 in the order book.

    That definition works pretty well for the exchanges, but it's probably a bit over-simplified. For example, say that the real value of the e-mini contract is holding steady at 1410.24, and an HFT has a too-large short position and buys a bunch of contracts from retail guys offering 1410.25. He has technically "taken liquidity" but I think it can be argued that there's a benefit to the market structure by doing so (certainly there's a benefit to the participants who placed the offers he's taking).

    In e-minis, I suspect what's going on is that a lot of algo traders have some kind of signal for whether the contract is about to tick up or down, and are taking the market when that signal fires. Or, they're trading a basket of the underlying stocks, and taking e-minis as a hedge once their aggregate position reaches a certain size. E-minis are a weird contract to study for understanding HFT-as-a-whole because of the lack of liquidity rebates and the close relationship to an underlying cash market.

  27. Posted by Guest | December 4, 2012 at 3:18 PM

    Please share your opinion if you disagree, but I do not think they are the same thing. A transaction's effect on liquidity in the market depends on its order type. Generally, a limit order demands liquidity while a market order provides liquidity. The buy / sell distinction doesn't matter as much.

  28. Posted by Texashedge | December 4, 2012 at 3:31 PM

    Ah, I was unaware of the semantics of providing vs. taking. Per your second paragraph, it seems to provide the same positive function of having more buyers and sellers able to convert assets and securities to cash and vice versa though. Anyway, thanks–why I come to this site

  29. Posted by Dikembe | December 4, 2012 at 5:07 PM

    you're third sentence is wrong, and it's not a matter of opinion but of definition.

  30. Posted by Guest | December 4, 2012 at 5:26 PM

    Why don't you go ask your mom…

    - 3rd grader.

  31. Posted by Texashedge | December 4, 2012 at 5:29 PM

    Well, I asked your mom this morning, but she had her mouth full and couldn't talk

  32. Posted by Guest | December 4, 2012 at 5:49 PM

    I was being polite. The third sentence is correct. Your use of "you're" is wrong.

  33. Posted by Guest | December 4, 2012 at 6:01 PM

    A market order always takes liquidity. A limit order can either take or provide liquidity depending on whether it is immediately matched against some other order in the book, or is added to the book before being traded against.

    Still, despite being way off, you probably have a much better understanding of HFT than the typical jackoff ranting about "parasites" and "front-running" on Yahoo Finance threads.

  34. Posted by Guest | December 4, 2012 at 6:21 PM

    In what sense is a limit order ever taking liquidity? It never crosses the market. It only trades when a market order hits it. Thus in any transaction involving a limit order, the limit order is the liquidity provider. I'd appreciate any article or link you can provide explaining your position. Thanks.

  35. Posted by Dikembe | December 4, 2012 at 8:54 PM

    you can place a limit order at any price, including one that crosses the market. it's called a marketable limit order. in fact, arca treats market orders in their system like a limit order with a very high price for buys and vice versa for sells. hence, you can't really formalize a defintion of liquidity providing and taking based on the order type. re the you're/your mistake, i usually type braindead because i am multitasking. but thanks for pointing it out.

  36. Posted by Guest | December 4, 2012 at 9:58 PM

    Oh. Got it. Thanks for the explanation. So, basically, a limit order can be placed at any price. If it crosses the market it will trade immediately, hence demanding liquidity. Otherwise it sits on the order book and supplies liquidity. Why would you place a limit order inside the market? The only thing I can think of is to ensure the market price doesn't get away from you.