Winner Takes All, and Liquidity Takers Win

 	08-11-10 © EpicStockMedia A new report stresses the extent to which the world of high-frequency trading is winner-take-all.

Three scholars behind “Risk and Return in High Frequency Trading” together address the questions: how do HFT firms make money? And, what is the nature of their competition with one another?

They start with some numbers: the median HFT firm has an enviable annualized Sharpe ratio of 4.3 and a four-factor annualized alpha of 22.02%.

The “four factors” involved in the calculation of four-factor alpha are: CAPM; market capitalization, book-to-market value, and momentum. These numbers indicate a very strong performance, and (the authors add) in contrast to other strategies this firm-level performance for HFT firms is “strongly persistent over both days and months.”

Speed and Liquidity Taking

So it does appear that speed is helpful in generating risk-adjusted profit. How is it helpful? There are, speaking broadly, two answers to this theory in the academic literature. First, there is the view that HFTs are aggressive takers of liquidity who “pick off stale limit orders or trade ahead of others’ information.”

The other view is that HFTs are passive market makers whose activity amounts of “mitigating adverse selection and providing tighter bids and asks.”

This paper, in its own effort to decide between those views, is the work of Matthew Baron, Jonathan Brogaard, and Andrei Kirilenko, respectively associated with Princeton University, the University of Washington, and the Massachusetts Institute of Technology.

Kirilenko’s name in particular is likely to be familiar to readers of AllAboutAlpha. He is the former Chief Economist of the Commodity Futures Trading Commission, and there was a moment in the middle of last year when he seemed to be the Julian Assange of Section 8 data.

Let’s cut to the chase: their bottom line is that the aggressive, liquidity-taking model of how HFTs make their money is the right one.

The Critics are Right

In the course of getting to that conclusion, they map out the industrial structure of a winner-take-all environment, one in which “the trader who is first able to identify and respond to a profitable opportunity will capture all the gains … [and other] firms who are even milliseconds late will miss out: the magnitude of the profit may be sharply reduced or the trading opportunity may have disappeared completely.” Successful HFTs earn alphas and Sharpe ratios that are many times those of the industry median.

This environment leads to investment in ever-faster technology to a degree that exceeds any socially efficient level.

Revenue, thus, is skewed to the right within the industry, and the concentration persists over time. Incumbents in the field have an advantage over entrants. Thus, the industry as these three authors picture it looks a lot like the pictures drawn by its harsher critics. HFT is “an industry dominated by a small number of increasingly fast, liquidity-taking incumbents with high and persistent returns.”

In working through to this conclusion, they look especially at the E-mini S&P 500 stock index futures contract. This seems to be a common ground for studies in this field, and these authors spend some time spelling out the reasons for that (such as that there is no “institutionalized class of intermediaries” in this market.)

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