High-Frequency Trading: Is it Good or Bad for Markets?

Study finds that high-frequency trading enhances market liquidity, reduces trading costs, and makes markets more efficient

Mar 20, 2013, 09:00 ET from Columbia Business School

NEW YORK, March 20, 2013 /PRNewswire/ -- As technological improvements reduce human interaction in financial markets, new research from Columbia Business School Professor Charles Jones details both the benefits and risks associated with high-frequency trading (HFT), the use of sophisticated computer algorithms to trade hundreds or even thousands of times a day, with a holding period often measured in seconds.

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Many financial markets now rely on electronic limit order books or other automated trading systems. High-frequency traders use computer programs to trade for their own account on these automated systems. Jones, the Robert W. Lear Professor of Finance and Economics, analyzed a substantial body of recent theoretical and empirical research on the risks and benefits of HFT. 

The study - which is the first meta-analysis on HFT - surveyed approximately 30 theoretical and empirical papers on the topic. Jones also weighed the merits of academic arguments, examined the regulatory landscape, and drew out key findings based on the facts. The results of the research indicate that HFTs and related technologies are making markets better, not destabilizing them.

"At a time when HFT has become a subject of regulatory focus, it is important that policymakers, practitioners, and researchers dispassionately assess the hard data of accumulated evidence on HFT's impacts," Jones said.

Many HFT strategies are not new, Jones explains in his study. Rather, they are familiar trading practices updated for an automated environment. For example, many HFT firms "make markets" (or quote both a buy and a sell price for a security) using the same business model as traditional market makers, but at a far lower cost thanks to automation.  While there is a theoretical risk that the speed of HFT could put other market participants at a disadvantage, these risks are not borne out in the data.

Overall, Jones found that HFT enhances market liquidity, reduces trading costs, and makes stock prices more efficient. Increased liquidity lowers the cost of equity capital for firms. In addition, the lower costs of automation can be passed on to investors in the form of narrower bid-ask spreads and smaller commissions.

"With a lower cost of capital, firms are likely to invest more, with commensurate increases in GDP," Jones writes in the new research. "And share prices are almost surely higher as a result of this reduction in trading costs, benefitting long-term investors."

A number of regulatory issues are currently being considered that could affect HFT, and some new policies have already been adapted or approved. Single-stock circuit breakers, which were phased in after the "flash crash" of May 6, 2010, force a five-minute trading halt if the transaction price of an individual stock moves by more than 10 percent within a five-minute period. The "limit up-limit down" mechanism, approved by the SEC in 2012, prevents trades in individual stocks from occurring outside an allowable price band during short periods of time.

"These price limits seem to be an appropriate speed bump," Jones concludes. "Other minor regulatory tweaks may be in order, but those formulating policy should be especially careful not to reverse the liquidity improvements that we have experienced in the United States over the past few decades."

The research was supported by a grant from Citadel LLC.

About Columbia Business School

Led by Dean Glenn Hubbard, the Russell L. Carson Professor of Finance and Economics, Columbia Business School is at the forefront of management education for a rapidly changing world. The school's cutting-edge curriculum bridges academic theory and practice, equipping students with an entrepreneurial mindset to recognize and capture opportunity in a competitive business environment. Beyond academic rigor and teaching excellence, the school offers programs that are designed to give students practical experience making decisions in real-world environments. The school offers MBA and Executive MBA (EMBA) degrees, as well as non-degree Executive Education programs. For more information, visit www.gsb.columbia.edu.

SOURCE Columbia Business School