Making sense of the fast — and the furious

Is high-frequency trading the most evil finance scheme ever conceived? Ryan Riordan crunches some hard-to-access data and comes away with a reassuring tale
Making sense of the fast — and the furious

The essentials

High-frequency trading (HFT) is a controversial form of hyper-fast trading using complicated algorithms in which stocks are bought and sold in milliseconds. HFT was blamed for the so-called Flash Crash of May 6, 2010, when the U.S. stock market fell roughly 1000 points, recovering 20 minutes later. Using data from NASDAQ and the German Stock Exchange, Ryan Riordan, assistant professor of finance at Queen’s School of Business, found that high-frequency traders do not use their liquidity supply to destabilize the market or engage in “quote stuffing.” They do, however, impose adverse selection costs on smaller investors

Ryan Riordan likes speed. On an overcast day in August, he hurries home to Peterborough, Ont. from Kingston, figuring out how to shorten the two-hour commute. 

A new arrival to the Queen’s School of Business faculty, Riordan finds himself in the enviable position of being one of a handful of experts in Canada on high-frequency trading (HFT), a controversial form of hyper-fast trading using complicated algorithms in which stocks are bought and sold in milliseconds. 

HFT is thought to allow for narrower bid-ask spreads, meaning investors are able to capitalize on price movements in the mere seconds between price fluctuations. High-frequency traders purchase shares when their price is lower than what’s trending and sell them when that price rises above that value. 

“It’s a relatively new phenomenon,” says Riordan, assistant professor of finance. “It’s also extremely difficult to get into the HFT research game just because there’s so much specific knowledge required and because getting access to data is difficult. The exchanges are worried about where this data is going to end up.”

What’s allowed Riordan access to this arcane field? “It was serendipity,” he says, noting his insider knowledge and industry connections provided him with sensitive data from stock exchanges. This in turn allowed him to conduct ground-breaking research on the effect of different trading speeds, regulatory fees, and share pricing.

Right Time, Right Place

Riordan has had the unique opportunity of studying HFT as a broker and an academic, beginning his career at HSBC automating trading functions, studying HFT as a PhD candidate, and finally undertaking research as a business school professor. 

During his PhD studies in 2007, he obtained data on computer-generated orders from the Deutsche Börse Group, the German Stock Exchange, as well as NASDAQ. His paper, “High Frequency Trading and Price Discovery” (co-authored with Jonathan Brogaard of University of Washington and Terrence Hendershott at the University of California at Berkeley), was born of this research. It paved the way for more study of whether or not retail trades suffer from high-frequency traders and how different network connectivity speeds influence market participant dynamics. 

Riordan attributes his good luck in accessing key data to timing: HFT was not under the microscope as it is today. Everything changed with the so-called Flash Crash of May 6, 2010, when the U.S. stock market fell roughly 1000 points, recovering 20 minutes later. The crash was largely blamed on HFT, prompting regulators, institutional players, and brokers to condemn the practice. Nobel Laureate economist Michael Spence called for an outright ban on HFT.

The Flash Crash also highlighted dirty practices such as quote stuffing — the flooding of the trading system with orders in order to confuse other investors and limit competition — and brought negative attention to the ever-increasing speed of trading, which was widely perceived as detrimental to smaller investors. The fallout made HFT a lot less profitable, causing many firms to shutter.

"All of a sudden, not only were a bunch of academics interested in what we were doing, everyone was interested in what we were doing”

But for Riordan, the Flash Crash opened doors. “At the time of the Flash Crash, I was at Berkeley and we were already working with a high-frequency trading dataset that we had put together at NASDAQ. All of a sudden, not only were a bunch of academics interested in what we were doing, everyone was interested in what we were doing.” 

Though he says he’s since discovered some negative aspects of HFT, such as the imposition of adverse selection costs on smaller investors by HFTs, he takes a rosier view of the practice than many.  

“There are good parts to it, there are bad parts to it,” he says. “It all depends on what behaviours they’re engaging in and that defines whether they’re bad or good. . . Their liquidity supplying activities appear to be beneficial for small investors and the market overall in that they reduce the costs to buy and sell securities. It's just when they're demanding liquidity that they seem to be harming the overall market. Fortunately for me, the verdict is still out on their overall impact.”

Riordan says he’s found no evidence that shows HFTs destabilize the market, something for which they were demonized since the Flash Crash. 

“When things get really crazy, we usually find that [the HFTs] just stop trading, they get out of there. And they pull back their demand rather than their supply,” he says. “One of the complaints was that they were using their liquidity supply to destabilize the market, and we found that wasn’t the case.”

Nor was there any evidence of quote-stuffing: the HFT orders were doing what the researchers believed they should be doing. “We generally gave them the thumbs up.”  

Cool Reaction to Findings

His take is not always well received. “At the start [the reception] was generally skeptical,” says Riordan, adding it takes him some time to convince the skeptics. “In a presentation on HFT, as soon as they see, ‘He’s not an HFT shill looking to sell us something,’ they usually see it differently.”

But the institutional players who are losing business to HFTs, such as the big banks and the traditional brokers who used to supply liquidity to the markets, are not buying his findings. To them, Riordan says, “It doesn’t matter how much evidence we present.”

In Canada, HFT is coming under increasing scrutiny. The Investment Industry Regulatory Organization of Canada has commissioned three independent teams to conduct studies, due to report by early 2015. One will look at the impact of HFT on liquidity, risk management, and information transmission. The second will look at the effects of short-selling by HFT traders on market liquidity, stability, price efficiency, and price discovery. And the third will examine the role of HFT traders as “market makers” in providing liquidity during periods of market stress.

There remains the possibility of high-frequency traders being taxed, charged higher fees to trade on markets, or excluded from trading in certain markets altogether.

 As for the future, Riordan foresees many HFTs selling their proprietary technology to “slower” traditional money managers or acting more like consultants. “Some of those who have cutting-edge technology will continue to use it. But at some point, they’re going to realize: ‘This is old news.’”  

Anna Sharratt

Smith School of Business

Goodes Hall, Queen's University
Kingston, Ontario
Canada K7L 3N6

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