The recent NYT article by Charles Duhigg on high-frequency trading (HFT) has set off a flurry of argument about the benefits and threats of this activity to financial trading systems. The revelation that some systems provide advance information (exposing incoming orders 30-500 milliseconds before they are submitted to the general market) to select HFT systems has drawn particular fire. Some have suggested that rapidity of response capability per se could open up manipulation possibilities or is otherwise destabilizing. We have also seen questions about whether diverting trade surplus toward whomever builds the biggest fastest network is an efficient use of resources, and the implications for perceptions of fairness across the trading public.
Let us start from the premise that asymmetry of information about incoming orders is inherently undesirable. Leveling the playing field in information promotes efficiency and lowers the cost of entry for the broader investing public.
The root of the problem, in my view, is the system’s support for continuous-time trading. In a continuous market, trades are executed instantaneously whenever there are matching orders, and introduction of an unmatched order likewise causes an instantaneous update to the information available to traders.
An alternative would be a discrete-time market mechanism (technically, a call market), where orders are received continuously but clear only at periodic intervals. The interval could be quite short–say, one second–or aggregate over longer times–five or ten seconds, or a minute. Orders accumulate over the interval, with no information about the order book available to any trading party. At the end of the period, the market clears at a uniform price, traders are notified, and the clearing price becomes public knowledge. Unmatched orders may expire or be retained at the discretion of the submitting traders.
Even with a period as short as one second, the call market totally eliminates any advantage of HFT systems. It does not eliminate the opportunities for algorithmic trading in general–just those that come from sub-second response time. No party has privileged information about order flow, and no party benefits by getting a shorter wire to the “trading floor”.
Moreover, the call market eliminates the disparity in risk incurred by those who dangle limit orders in continuous trading systems. Given the latency in retracting an order, an HFT system can take advantage of existing orders when new information becomes available. Because of this, systems need to provide extra incentives for the so-called “liquidity providers” who are willing to maintain a limit order. In the discrete-time systems, nobody can hang back and prey on liquidity providers. In order to trade, one must incur the one-second (or whatever) exposure. But everyone is doing that, and no information about orders becomes available anyway in that interval, so this exposure spreads out the risk evenly.
Finally, call markets also have efficiency advantages over continuous mechanisms. Aggregating orders over time eliminates some of the noise in matching based on arbitrary arrival sequences, thus producing higher surplus overall, and less price volatility. There is a classic tradeoff here between efficiency and execution delay. But with clearing intervals as short as a second, it seems hard to argue that this delay has very much real cost.
Switching over to discrete-time systems entails some technological changes, all well within feasibility in my view. The conceptual change of mindset required of the trading community may be a more serious challenges, but the benefits could be immense.