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HFT Really Does Reduce The Bid Ask Spread; Making Michael Lewis Wrong About HFT

This article is more than 9 years old.

I wrote yesterday about the manner in which Michael Lewis has got the wrong end of the stick about high frequency trading in this new book. Many commenters seemed a little unhappy at the idea that they weren't going to be able to continue shouting about how Wall Street was ripping everyone off as a result of my gentle corrections to Lewis' views. So, today, a little more detail about where my views come from.

For example, this slide set, Does Algorithmic Trading Improve Liquidity?, where the answer is yes, yes it does. Of particular interest is slide three, showing the decline in the bid ask spread over the years. From perhaps 0.17% in 1994 to 0.025% in 2004 or so. Yes, this was indeed a time when HFT was increasing and you can read through the rest of the set to see how they link the two processes. And, as I said yesterday, if the bid ask spread is reducing then this saves money for all investors. Simply because you've got to hand over less money to the middlemen when you buy and or sell.

Here is a quote about what has happened since that 2004 paper:

Bid-ask spreads have fallen by an order of magnitude since 2004, from around 0.023 to 0.002 percentage points. On this metric, market liquidity and efficiency appear to have improved. HFT has greased the wheels of modern finance.

Here is something from just last week on the subject:

 U.S. regulators are unlikely to put rules in place that would harm high-frequency trading (HFT) as doing so would make trading more difficult and expensive for all investors, Robert Greifeld, chief executive officer of Nasdaq OMX Group said on Thursday.

You might want to argue that of course the Chairman of NASDAQ would say that, wouldn't he? But it is at least consistent with my story, that HFT reduces trading costs by providing greater liquidity and thus smaller bid ask spreads.

Or here's Matt Levine this morning:

In my alternative Michael Lewis story, the smart young whippersnappers build high-frequency trading firms that undercut big banks' gut-instinct-driven market making with tighter spreads and cheaper trading costs. Big HFTs like Knight/Getco and Virtu trade vast volumes of stock while still taking in much less money than the traditional market makers: $688 million and $623 million in 2013 market-making revenue, respectively, for Knight and Virtu, versus $2.6 billion in equities revenue for Goldman Sachs and $4.8 billion for J.P. Morgan . Even RBC made 594 million Canadian dollars trading equities last year. The high-frequency traders make money more consistently than the old-school traders, but they also make less of it.

Or Felix Salmon:

Similarly, Lewis goes to great lengths to elide the distinction between small investors and big investors. As a rule, small investors are helped by HFT: they get filled immediately, at NBBO. (NBBO is National Best Bid/Offer: basically, the very best price in the market.)

And because the greater liquidity has crushed those bid ask spreads then the small investor is getting very much better prices than they used to.

We've come down nearly two orders of magnitude in that bid ask spread in the past 30 years. From around 0.20 percent to some 0.002 percent. That's saved every investor huge amounts of money over all the trades they've done. It's simply not true to say that HFT has been filling the pockets of the traders at the expense of investors. HFT has been moving the money out of the pockets of the older traders, working on the wider bid ask spreads, and moving it into, in smaller amounts and smaller percentages, the pockets of the newer traders. And it's the consumer, the investor, that has been pocketing the difference between the two sets of numbers, the old margins in the stock market and the new smaller ones. Very much to the benefit of said consumer, said investor.