I came across an interesting paper the other day published by GETCO: A Modern Market Maker’s Perspective on the European Financial Markets Regulatory Agenda.

The HFT community has come in for quite a bit of stick recently and so it was refreshing to see an intelligent and well argued explanation of its role in today’s financial markets.

One of the key points GETCO makes is that high frequency trading is not a trading strategy in its own right. Instead, trading with high frequency (or with high speed and volume) can reflect a number of different trading strategies. Where it is supporting electronic market making then speed is crucial as the market maker needs to minimise his ‘exposure time’, i.e. that period when he cannot modify a quote in response to changing market conditions. At least for market making, then, high speed is actually a way of reducing risk rather than increasing it.

The paper goes on to say that electronic liquidity providers like GETCO actually increase overall liquidity and reduce volatility by buying when others want to sell, and vice versa. The real debate, though, stems from exactly how obliged the ‘modern day market maker’ is to maintain these two-sided quotes especially when markets are volatile. GETCO rightly argues, however, that its role as designated market maker (DMM) or Lead Market Maker (LMM) on many venues and stocks means that it is subject to very specific obligations in this regard. And so, ironically, the faster GETCO can access markets the safer they would appear to be.

The other issue is how such firms are rewarded for their provision of this liquidity to markets. In the old days market makers earned the bid/ask spread between the quotes that they provided but this has changed since the introduction of MiFID.  First, the maker taker pricing models operated by many alternative venues provide extra reward (in terms of rebates) to those firms that lodge passive liquidity on their platforms. Second, the increased competition between the venues has led to an overall reduction in tick sizes which favours electronic liquidity providers over the more traditional market maker.

I guess the problem comes with the high frequency players that simply siphon liquidity between venues in order to take advantage of maker taker rebates without any real obligation to consistently make two-sided markets.

Anyway, read the paper and let me know what you think. Is HFT an inevitable consequence of competition between venues and does it benefit the market overall by increasing liquidity and smoothing volatility, or is it a dangerous activity that benefits only its practitioners and increases overall market risk?