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1 October 2015 CFA Institute Journal Review

High-Frequency Quoting, Trading, and the Efficiency of Prices (Digest Summary)

  1. Paul Lebo

The authors seek to resolve the widely debated effect of high-frequency trading (HFT) on market quality. Unlike prior studies, which have been limited to a single exchange, the authors examine the effect of HFT on aggregate market behavior to inform overall market prices. Using several tests, they conclude that market quality is actually enhanced by the presence of HFT.

What’s Inside?

The authors use several tests to determine whether high-frequency trading (HFT) is a hindrance to or a facilitator of market quality. Using empirical support, the authors find that the tests bolster the view that HFT is beneficial to market quality. There are certain exceptions to one of the tests, however, such as the Flash Crash of 6 May 2010. The authors explain that market disruptions have always occurred, and thus HFT is not a silver bullet that can prevent every disruption.

How Is This Article Useful to Practitioners?

In light of the public skepticism toward HFT, partially driven by Michael Lewis’s New York Times best-selling book Flash Boys (W.W. Norton & Company 2015), the authors provide practitioners with ammunition to use in their client meetings. In Flash Boys, Lewis outlines a stock market that is not a level playing field for the retail investor and the smaller investment shops versus the largest financial players, which have the ability to front-run trades. With this claim running rampant through the media, investment advisers and portfolio managers are faced with periodic queries from clients who question the legitimacy of the stock market and whether they are obtaining the best execution.

As investment advisers have struggled to answer this question over the past year, many could sidestep the question on HFT by focusing on the long-term nature of their clients’ portfolios. For example, even if there was a situation in which best execution could not be obtained, how much would it affect the portfolio returns of a long-term investor? According to this viewpoint, stock picking and asset allocation have a much more significant effect on the returns of a long-term investor than the fractions of a cent to be earned from best execution through HFT.

Other investment advisers may have focused their answers on the theoretical benefits of HFT to market efficiency. According to this perspective, the world as portrayed by Flash Boys is not an accurate representation of the actual stock market, and in fact, HFT produces tangible benefits for the common investor. Although this argument certainly has theoretical merit, without academic research, such as this article, it may not adequately address clients’ concerns.

How Did the Authors Conduct This Research?

The authors use conditional and unconditional tests to determine whether HFT is a hindrance to or a facilitator of market quality. They examine the behavior of stock prices for a cross section of US securities from 2009 to 2011 and Japanese securities from 2010 to 2011.

The first test measure is the relationship between quote updates and variance ratios over short horizons, which seeks to determine whether HFT pushes stocks toward or away from fundamental values. The second test measure examines the resilience of the market in the presence of HFT using price formation and trading costs in the context of significant, quick drawdowns in market liquidity.

Abstractor’s Viewpoint

The authors have produced a timely and engaging piece that is a must-read for practitioners in the investment management industry. I encourage the authors to conduct further research on this topic.

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