THE BIG LIE ABOUT HIGH FREQUENCY TRADING (HFT)

The following article was written by Karl Denninger and appeared at http://market-ticker.denninger.net/authors/2-Karl-Denninger in August 24 2009.

THE LIE OF HIGH FREQUENCY TRADING LIQUIDITY
by Karl Denninger

There is an oft-repeated lie that "High Frequency Trading" adds lots of liquidity to the market, and thus is a "good thing."

But repeating a lie a thousand times does not make it true. It just makes you a damn liar instead of an ordinary liar.

Let's postulate two HFT computers passing 1,000 share orders for the mythical Frobozz (FBOZ) back and forth between each other. There's a scadload of volume generated by these transactions, and an outside observer, who is unaware that the 1 million shares are in fact 1,000 transactions of the same 1,000 shares being passed back and forth between the same two guys, might assume that there's a lot of liquidity that has been added.

But this is in fact misleading, as the following example will demonstrate.

Let's say you see these 1 million shares transact over the space of an hour, and as such you come to the assumption that this issue is very "liquid." This is good, because you, as an institutional (read: Mutual Fund) manager want to buy 20,000 shares of Frobozz for your fund. 20,000 is a small percentage of the 1 million shares that traded in the last hour, so you believe this is a very liquid issue and you should have no problem getting a decent price.

But there is really only one 1,000 share lot that has generated all these trades and volume that these guys are passing back and forth between themselves!

So when you put in your "buy" order the HFT guys jump with glee, because they just screwed you - their pumped price gets "sold to you", but worse, the offer suddenly disappears, because there was in fact only 1,000 shares out there - all the other "offers" and "bids" were REFLECTIONS that the computer can cancel faster than you can hit them, and they DO! As the offer collapses the price skyrockets, and the rest of your order executes at a very nasty price indeed.

Now the smart institutional guy would not stick an order like this out as a market order, but the point remains: in a truly liquid market, where HFT had added true liquidity, a market order would be perfectly safe as that 1 million share print over the last hour would represent ACTUAL LIQUIDITY in the market.

It does not.

HFT is nothing more than sophisticated (and in some cases legal) front-running. It does not add material amounts of liquidity in reality to the market as it is all "hot money" looking to do one thing: steal a few pennies from each transaction. It is not a "pool" of liquidity, it is a set of computer programs that are in fact passing the same shares back and forth between each other in the direction of the short-term trend (perhaps as short as a few seconds!) looking for a bagholder to offload their "momentum-driven shift" to.

Never confuse volume and liquidity - they're not the same thing.

1 million shares consisting of two guys handing the same thousand-share lot back and forth present almost no liquidity to the marketplace, as there is no depth to their book nor the intended holding period, and most of the "orders" presented by these guys are never intended to be executed - they're "feelers" looking for someone - anyone - who will take the overly-ripe bag from them.

No depth and no holding period (or almost none!) is the definition and intent of high-frequency trading.

That is the rule, not the exception.

These systems do not add liquidity - they add volume in an incestuous relationship with the exchanges which, of course, are not paid on liquidity - they are paid by the share, that is, by volume, as is your local retail broker.

Don't fall for the BS; HFT is just another scheme dreamed up by the Wall Street "boyz" to screw the retail and institutional customer alike.