Every month, The Big Question video series brings together a panel of Chicago Booth faculty with industry experts for an in-depth discussion. This is an edited excerpt from October’s episode, in which John C. Heaton, Joseph L. Gidwitz Professor of Finance and deputy dean for faculty; Tobias J. Moskowitz, Fama Family Professor of Finance; Eric Budish, associate professor of economics; and Stephen Brodsky, CEO of Spot Trading, analyzed the effects of high-frequency trading on financial markets. The discussion was hosted by Hal Weitzman, Booth’s executive director for intellectual capital.
Hal Weitzman: How important is high-frequency trading nowadays to financial markets?
Eric Budish: High-frequency trading is commonly attributed as constituting more than half of volume across a wide variety of markets. These firms trade at lightning-fast speeds, in unfathomably small amounts of time. They’re also sophisticated information technology firms. When we think of financial markets over the last few decades, there’s a lot of evidence that IT has benefitted fundamental investors in lots of ways. But some aspects of the speed race—I take your millisecond latency and try to be ever so slightly faster—have negative consequences.
Weitzman: What effect has this ever-faster trading had on markets?
John C. Heaton: If we just define high-frequency trading as use of technology, by definition it has had a massive impact in terms of increasing liquidity. It’s open to debate whether it’s had a major impact on liquidity, per se, independent of the technology itself. The other thing in terms of thinking about size is that, if you think about fees or profits, standard mutual funds would dwarf this industry many times over.
Weitzman: One concern is that exchanges pander to high-frequency traders, building expensive facilities where these traders can colocate their computers next to the exchange’s matching engine and get the fastest possible trading times. The allegation is that there’s a two-tier market. The high-frequency traders have privileged access, either to information or to certain kinds of trades, and mom-and-pop investors are left out. How is that criticism viewed within the industry?
Stephen Brodsky: It’s important to acknowledge where we’ve come from, and you can’t look at the technology developments isolated from the regulatory developments. All this came out of an environment where you had a specialist system, a floor-based exchange model, and very little transparency into what was going on in the marketplace. You had high fees and slower turnaround times for retail investors. It’s important to have that in mind when you start talking about things like colocation. Firms colocate in exchange facilities to be near the servers to generate the types of latency we talked about earlier.
Weitzman: …and pay huge amounts of money for the privilege…
Brodsky: They pay, and I could have gotten the same privilege 10 years ago if I paid $2 million for a New York Stock Exchange seat. Today, if you are willing to invest in technology, the exchange, by rule, has to treat everyone equally. This is important when you talk about colocation. If you remove it, all that’s going to happen is that the most valuable piece of real estate is going to be the building next door to the exchange. The good thing about the way it’s structured today is it’s regulated. The exchanges are responsible for making sure that it’s fair across members.
Budish: I have no nostalgia for financial markets in the 1990s. That said, my research suggests that current financial market design is flawed in that trading occurs in continuous time—investors’ algorithms can trade at any instant of the trading day. That’s problematic. First, continuous-time trading builds in a speed race: any time there is news, market participants race to react. If I react a millisecond faster than you, I win the right to trade on that information. Secondly, my research shows that the speed race has negative consequences. It harms fundamental investors by reducing liquidity. It’s destabilizing for financial markets, making them more vulnerable to events like flash crashes.
Weitzman: Is market stability affected by this
Tobias J. Moskowitz: Eric’s research does show some of that, but generally, it’s not quite clear. There’s evidence that in some markets, flash crashes typically occur in the absence of high-frequency traders, when they were removed from the market. It’s hard to blame them for being there and causing things, as well as when you remove them. Even if we do blame them for some of these rare events—and I’m not sure that’s even clear—the question is, are there other benefits? You may be willing to tolerate the occasional additional flash crash if, 99% of the time, you get better liquidity, maybe less volatility, maybe all kinds of other things that we haven’t quite documented across all of these markets.
Budish: I think of the culprit as continuous trading, not high-frequency traders. A lot of the public-policy debate is around whether high-frequency trading is good or evil. That’s the wrong debate. The debate we should be having is whether continuous-time trading is the right market design.
Weitzman: Tell us about your alternative.
Budish: We’re proposing that financial exchanges use what we call batch auctions at very frequent but discrete time intervals, such as once per second. For each stock, future, or other contract, once per second there would be an auction. Investors and marketmakers would submit bids and asks, the way they currently do, and the market would clear where supply meets demand. Anybody who’s willing to pay more than the market clearing price or sell for less gets to trade at that price. By moving from a continuous-time design to a discrete-time design, you eliminate the incentive to spend substantial amounts of money on tiny speed advantages.
Brodsky: That feature of trading today has become commoditized. There are more firms able to spend money on this type of technology. There’s a limit to how far this can go, and you hit a plateau and then really it’s just a zero-sum game between marketmakers. Where things have moved is, how do you apply the technology to other things you do well—analytics, valuation, access to customer order flow, providing liquidity to customers? There’s always been this tension between marketmaker rights and obligations and speed. If you want to slow things down, you give all marketmakers certain benefits. That will slow it down. That will bring stability to the marketplace, but at a cost.
Weitzman: Who would actually institute this rule? The regulators?
Budish: The cleanest way would be via regulators. I’m not pro- or antiregulation, but the current market structure is a product of regulation, and frequent batch auctions are smarter regulation than the continuous-time design.
Heaton: Another interesting issue of coordination is across securities. We all talk about liquidity. Really, when we’re talking about high-frequency trading, it’s mostly in large cap stocks. I’m not exactly sure how this mechanism helps or hurts trading in small cap stocks and how to coordinate the auctions across the stocks. I’m the last person to advocate regulation, but to implement what Eric has in mind, you would need a national regulatory body.
Weitzman: Would this be a step forward?
Moskowitz: It depends. We’re still gathering the evidence. It would be nice to let the exchanges experiment a bit. Eric’s proposal’s extremely interesting, and it does solve some potential problems. We don’t know necessarily what the unintended consequences might be. This would be a way to find out.
Budish: There are regulatory impediments to exchanges experimenting with frequent batch auctions. But I’d like to see individual listed companies be able to elect for frequent-batch auctions over the current market structure. CEOs of listed companies say, “My stock trades in a casino. Why does my stock need to trade at a millisecond?” I like the idea of allowing listed companies to elect a different market structure, but the current regulatory environment would prohibit that. The regulation assumes that retail and fundamental investors really want immediate execution.
Heaton: But the trade-off is that they want the open market structure so there’s competition for investment, so the investors with local understanding of markets don’t get exploited. There’s a good reason some of that’s there. We have to be a little careful about relaxing some of those regulations.
Brodsky: The second you have two market models trading the same security or heavily correlated security, you inevitably inject race and speed into the equation. If the goal is to eliminate that as an input, so all of us can invest more in providing liquidity, I’m not sure it gets there unless there’s a very large regulatory mandate, and I’m talking about a central limit order book for every correlated product. My concern would be, unless you’re willing to go all the way to that, I’m exposed to being held up in an auction.
Budish: If I can bring this debate with my research to where a panel of experts says, “We agree that continuous-time markets have problems and that frequent batch auctions are a good idea in theory, but there are regulatory complexities with implementing that idea,” I’ll consider that a tremendous victory.