Are There Really Good and Bad HFTs?

After writing a half dozen HFT posts all which remain unpublished in draft form, I will cut right to the proverbial chase in a last-ditch attempt to vomit my thoughts into the public domain: despite my predisposed feelings to the contrary, I reckon there is little practical difference between "good" and "bad" HFT and therefore market-structure should be leveled to reflect this.

Let me state at the outset: I am naturally sympathetic to bona-fide market-makers like Tom Petterfy & Timber Hill (one of the earliest and most thoughtful innovators using computerized technology for market-making purposes) chiefly because, in the main, they are attempting to a capture a portion of the bid/ask spread in exchange for risking capital by providing immediate liquidity. Likewise, I am naturally suspicious of predatory HFTers who have no natural raison d'être to transact and are, at best parasitic, and worst, criminal. These participants in the market ecosystem, like frigate birds, prey upon bastardized market structures,  ultimately disadvantaging, on-average, bona-fide buyers and sellers evidenced by the extraordinary profits derived from the undertaking.  In the increasingly vocal debate following Lewis' PR onslaught, and Schneiderman's attention, for the record, I think Dave Lauer (@dlauer) has it right, "@ModernMarkets" is no more informative than Radio Pyongyang, Craig Pirrong (@StreewiseProf) is thoughtful with a usefully wide-reaching analytical framework but off-the-mark in estimating the ratio of nefarious activity, while the NANEX/Themis (@nanexllc & @joesaluzzi) nexus has consistently been the most vociferously transparent shiners of light into the darkest most contentious corners of both structure and abusive practice - a position sadly not helped by their too-often overly-strident timbre and their adoption by the tin-foil hat brigade as anti-establishment marauders.  

On the basis of the preceding, one would have thought I would support advantages to bona-fide HFT market-makers and desire to impose restrictions upon predatory HFT. Both views suffer slippery slope arguments, and they are, despite what I consider to be divergent virtues, in essence, more the same than different.

Dr. Pirrong makes an important contribution highlighting the drive that electronic market-makers pursue to combat adverse selection resulting from informed trading.  Informed trading can range from immense orders, for quantities and a time-scale larger/longer than even the best capitalized bona-fide market-makers can supply, to private possession of material non-public information. Bona fide market-makers pursuing spread-capture strategies, typically have no view, and will always be on the wrong side of informed trading which is why Petterfy protests so loudly when there is obvious malignant activity before a high-profile takeover.  The depth and breadth of private material non-public information being acted upon in the market, remains underestimated. Whatever MMs capital and time-frames, their spread-capture, must exceed the drag of this adverse selection (being on the wrong side of liquidity supply that never comes back). The more informed the trading, the greater the necessity to avoid adverse selection by widening spreads, diminishing quote size, narrowing stops, or outright limiting or eliminating exposure where one estimates the presence of informed trading. And make no mistake: this is highest in the equity shares of public companies. In its simplest distillation then, bona-fide market-makers seek to deploy their capital, to the greatest extent possible, only to random or noise-like activity to capture some of the spread.

Predatory HFT (of which there are many flavors and time frames), in its simplest distillation,  seeks to avoid the deployment of capital in bona-fide market-making activities where they are exposed to adverse selection, focusing instead on strategies that commit as little capital as possible to pay lip-service to market-making for structural advantages (latency, rebate, order information) that allows either a risk-less arbitrage between venues, or high-probability predatory bets that for all intents appear indistinguishable from front-running.  On average, this intermediation increases the cost of trading, though likely moves the price more rapidly in the direction where its going in the presence of informed trading. Some term this movement greater efficiency, but as highlighted in Stiglitz' argument against HFT, it taxes information, transferring wealth from those with information (however appropriated) to the (free-riding) frigates who are adept at spotting others heavy with information.    

Bona-fide market-makers attempting to avoid adverse selection creates a slippery-slope. Where is the line and what is time frame? There appears no possible line of demarcation between limiting or avoiding adverse selection and using the same information for positive selection.  Just a smooth continuum. Why, one might ask, be content just limiting negative exposure? Why not, where one suspects the presence of PIN, warehouse or positively discriminate one's markets to get on the right side of it? Few, if any, in my two and one-half decades of experience - not specialists, not jobbers, not market-makers, not brokers, have shown themselves able to avoid using the possession of an advantaged position for private profit. So despite my distinction centered on intention and virtue, I see no reason to confer advantage to someone rather likely to abuse them.    

Predatory HFT are cynically trying to do the same thing using their conferred advantage within the markets as presently allowed and structured. There are many calls for all manner of outright restriction and regulation. The slippery slope centers on what, precisely, is "bad". Is it short-term speculation? If so, how short? Yes, certainly some things are illegal (quote  stuffing, spoofing etc.) But the essence of the most egregiously blatant abuse (with respect to the market and welfare) is the abuse of a structurally-privileged position - be it proximity, latency, or order information.  Some argue such abuse of privilege has existed for as long as markets have existed. And this is true, but so what. This is not setting the bar very high. We cannot, and with high likelihood, should not prevent speculation at almost any time frame given its slippery slope.  But we have the means to be better, and fairer and we certainly shouldn't positively promote and effectively subsidize the activity whether by selective designation and privilege, promotion of fragmentation or similar.

There are undoubtedly people who understand the minutiae SIPs and regs better than I. Like Dave Lauer.  Fundamentally, I am certain technology is good for markets. It is both democratizing and empowering. More importantly, I believe that bona-fide activity and integrity are good for markets; that if you enter the market to buy are sell a quantity, you should be willing to trade at the price and in that quantity, whatever the next quote-change or print. I am in favor of punting at whatever timeframe - whatever its utility. Without conferred structural advantage, guessing games can be minimized by execution games (as they have for time immemorial).  I think fragmentation is bad for markets. It may be good for certain brokerage participants, sponsors and exchange shareholders, but  I have yet to see a convincing argument how this fragmented structure can possibly deliver utility, fairer, more equitably, more efficiently, with more integrity than a single, well-run venue where everyone is equal before the rules, and the rules are laid down to best promote trade in as frictionless, cheap, and transparent mode as possible. Yes, perhaps back then, it was easy to do something better and fairer than the NYSE or NASDAQ market-making club, when neither exchange, nor their members, nor captured regulatory or oversight body had any concern for something one might term the Public's Interest.

There... its out. This was more for me, and now I feel better. It really should't be contentious. But sadly, most participants seem to put their private agenda's before the public interest. Nothing new about that, in America at least…..