Email of the day 2
Comment of the Day

January 20 2014

Commentary by David Fuller

Email of the day 2

More on high-frequency trading (HFT):

Many thanks for drawing our attention to this impressive academic report: The High-Frequency Trading Arms Race: written by Eric Budish, Peter Cramton and John Shim.  Here is the introductory paragraph:

We argue that the continuous limit order book is a flawed market design and propose that financial exchanges instead use frequent batch auctions: uniform-price sealed-bid double auctions conducted at frequent but discrete time intervals, e.g., every 1 second. Our argument has four parts. First, we use millisecond-level direct-feed data from exchanges to show that the continuous limit order book market design does not really “work” in continuous time: market correlations completely break down at high-frequency time horizons. Second, we show that this correlation breakdown creates frequent technical arbitrage opportunities, available to whomever is fastest, which in turn creates an arms race to exploit such opportunities. Third, we develop a simple new theory model motivated by these empirical facts. The model shows that the arms race is not only socially wasteful – a prisoner’s dilemma built directly into the market design – but moreover that its cost is ultimately borne by investors via wider spreads and thinner markets. Last, we show that frequent batch auctions eliminate the arms race, both because they reduce the value of tiny speed advantages and because they transform competition on speed into competition on price. Consequently, frequent batch auctions lead to narrower spreads, deeper markets, and increased social welfare.


David Fuller's view

I recommend that you read at least the first two pages of this paper because it is a most welcome, thoughtful analysis in every respect.  It is also a good read, including the recent spending of approximately $300 million on a cable between New York and Chicago, to shave 3 milliseconds “an eternity” off order placement time (“the blink of a human eye lasts 400 milliseconds”) only to find out that the cable is already obsolete because of our “planet’s pesky curvature.”    

Computerised trading systems have been around for a number of years and that reality will not change.  However, for several years Eoin and I have been saying that HFT was a predatory, front-running system based on speed of execution. As such, it is probably illegal.  I see no reason to change that view.  

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