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Research paper on HFT (High Frequency Trading)...an argument for change
From Abstarct: "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."
It is interesting to note in this context that pre-hype has began for a new book titled 'Flash Boys' from Michael Lewis, author of Liar's Poker, Big Short, Money ball, etc to be released in March. While the publisher is tight-lipped about the subject matter, it is rumored to be about HFT participants.
Reply to @cman: For me, the bigger question is: How do we tell these Big Boys to get back into a row boat after letting them build and operate submarines?
Using another analogy; once we post the speed limit (on orders), how many cops will catch highway speeder vs. the number of speeder taking on the calculated risk of speeding?
Finally, this potentially explosive timing dynamic reminds me of the inner working of a nuclear reactor. Control rods are inserted to reduce (absorb freed nuetrons) the number of reaction (trades) and thus avoiding a meltdown.
Can a mild trading tax (pick a number, 0.025% of transaction value) work? It should not significantly affect costs for a buy-and-hold investor or small-time trader.
Reply to @Kaspa: Depends. Is the tax proposed by a Democrat or a Republican? But seriously, solving this with taxing is a political solution not a financial one. It just becomes another cost of doing business if too small and if it is too high it will stop it in which case, it is the same as banning it. But the unintended consequences of such taxation are potentially high.
I agree that the continuous limit order book is flawed. But why not have longer time intervals like five minutes (instead of one second)? I expect Wall Street market makers to fight for the existing system where they benefit from an unfair playing field.
I am against a transaction tax on all trades, but a better idea is a tax on trade cancellations. Some high frequency programs cancel 99% of their trade orders because they use numerous phony odd lot orders to sniff out what is on the limit order book.
The most unfair feature now is broker internalization which occurs with or without high frequency trading, where a broker can jump in front of a limit order by 0.0001, but retail investors cannot.
It is ironic that E-Bay has much fairer auctions than our stock exchanges. Imagine you were at an art auction where the minimum increment was $100, but the auction house was allowed to jump in front of the final winning bid by $0.10 whenever they wanted. That is how our stock exchanges work now with limit orders.
Reply to @MOZART325: That's exactly the proposal of this research paper...they call it frequent batch auctions. From the initial post: ..."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."
Comments
Using another analogy; once we post the speed limit (on orders), how many cops will catch highway speeder vs. the number of speeder taking on the calculated risk of speeding?
Finally, this potentially explosive timing dynamic reminds me of the inner working of a nuclear reactor. Control rods are inserted to reduce (absorb freed nuetrons) the number of reaction (trades) and thus avoiding a meltdown.
I always like this simple illustration (need Ted's help to post YouTube videos directly):
youtube.com/watch?v=Pmy5fivI_4U
significantly affect costs for a buy-and-hold investor or small-time trader.
I am against a transaction tax on all trades, but a better idea is a tax on trade cancellations. Some high frequency programs cancel 99% of their trade orders because they use numerous phony odd lot orders to sniff out what is on the limit order book.
The most unfair feature now is broker internalization which occurs with or without high frequency trading, where a broker can jump in front of a limit order by 0.0001, but retail investors cannot.
It is ironic that E-Bay has much fairer auctions than our stock exchanges. Imagine you were at an art auction where the minimum increment was $100, but the auction house was allowed to jump in front of the final winning bid by $0.10 whenever they wanted. That is how our stock exchanges work now with limit orders.
http://www.defendtrading.com/subpennying.html
From the initial post:
..."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."
Thanks for the other thoughtful points.