Haim Bodek - The Problem of HFT - Collected Writings on High Frequency Trading & Stock Market Structure Reform

Prior to 2009 I believed that modern high frequency trading (HFT) was simply another name for automated or electronic market making (AMM or EMM) , the predominant form of algorithmic liquidity providing activity present in US equity markets over the period from 2000-2007. Like most outsiders to HFT, I hadnt yet fully grasped the significance of the bifurcation of automated strategies in cash equities markets. The split had resulted in the ascendancy of a new breed of high frequency turnover scalping strategy. These inventory-neutral strategies, which focused on capturing exchange rebates on electronic exchanges running the maker-taker market model, eventually evolved into what we now know as modern HFT.

As it turns out, t he practices of these new market makers were indeed very new, radically different from the AMM/EMM tradition. Where traditional AMM/EMM desks focused on competing for order flow and typically scaled through risk capacity in conjunction with superior quantitative pricing and risk management methods, HFTs leveraged technology and market microstructure to achieve an edge over the market. HFTs were also markedly different when it came to how they handled risk, scaling up volumes using frequency while keeping risk exposures within highly constrained inventory limits. Unlike automated market makers, HFTs werent focused on acquiring exclusive order flow arrangements. Instead, they focused on asserting influence over the market structure itself to accommodate the requirements of specific HFT strategies. HFTs were masters of leveraging the plumbing of electronic exchanges to get an edge. With automation, the US equities market had evolved into a vast complex machine, one that was purposefully well-tuned to the nuances of HFT scalping strategies.

Modern HFT wasnt a paradigm shift because its innovations brought new efficiencies into the marketplace. HFT was a paradigm shift because its innovations proved that anti-competitive barriers to entry could be erected in the market structure itself to preference one class of market participant above all others. In practice, these barriers trumped other advantages such as captive order flow arrangements. The HFT business strategy was to work with exchange partners to align the features of the exchange with the features of the algorithmic strategies themselves. The primary goal of achieving superior queue position in the order book was the most coveted, but certainly not the only advantage sought. And, given the volume potential of these strategies and the competitive pressure that the exchange industry faced, a number of for-profit electronic exchanges determined that it was in their interest to help HFTs achieve the requisite market microstructure changes that would assist HFT strategies in getting an edge over the electronic crowd.

Indeed, HFTs became the dominant form of trading in the US equities markets through the assistance of the electronic exchanges themselves. In pursuit of mutual gain, the exchanges provided HFTs unfair and discriminatory advantages over public customers through a number of innovations released in US equities market over the last five years. The real paradigm shif t that HFTs brought to US equities markets was, therefore, the construction of trading environments tailored for specific trading strategies.

It became about meeting the needs of that specific HFT community, says a technologist who worked for several top ECNs and exchanges in the 2000s. Its all about what functionality I can offer the HFT that they can take advantage of. We are going after guaranteed economics.

The close relationship between HFTs and electronic exchanges evolved over the past decade without sufficient regulatory oversight. It shouldnt be surprising that a dynamic evolved where HFTs rewarded exchanges that provided such guaranteed economics with their orders. HFTs were opportunistic traders and they demanded an edge to trade. If they didnt find a compelling enough edge at a particular exchange venue, they would trade somewhere else or stay out of the market altogether. The proliferation of market centers in the US equities marketplace provided the HFTs with many choices of venue, so they naturally directed their volume to exchanges that accommodated their needs.