On high frequency trading and liquidity

The volume of trading on a market has often been used as proxy for the liquidity of the market.  Of course, the only reason that volume can function as a proxy for liquidity is because it is an indicator of the degree to which a financial asset trading on the market can be sold without changing prices.

It should be clear that the definition of liquidity that is important to the typical investor who trades on markets is precisely the latter:  Can I trade without affecting prices?

For this reason, claiming that high frequency traders provide liquidity to markets is simply foolish.  The goal of high frequency traders is to profit off of the infinitesimal (microseconds are the current unit of measure) timing differences between when small scale buy and sell orders arrive in the market.  In some sense, their goal is to ensure that every 1000 share sale on the stock market reduces the price of the stock and that every 1000 share purchase on the market increases the price.  By ensuring that every 1000 share order moves prices, they have two effects on the market:  first, they reduce liquidity and second, they increase the volume of trades on the market.

The fact that this “innovation” that reduces market liquidity has been permitted by all of the major stock markets in the US has driven the growth of off market trading in the form of “dark pools” (link: h/t zero hedge).

Another important factor to keep in mind when analyzing the value of high frequency traders is that the economic models that support the idea that self-interested behavior is socially valuable assume perfectly liquid markets.  Every change in market structure that reduces liquidity – in the sense of increasing the effect of small trades on prices – is a change that increases opportunities for rent-seeking and thus reduces the value of the market to society as a whole.

Our financial markets are by and large self-regulatory organizations.  If they cannot be managed in this form with the goal of minimizing the effect of small trades on prices, then perhaps they need to be changed into regulated organizations.

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