High-frequency trading firms earn consistent profits at the expense of smaller and retail participants, according to a study co-authored by the top economist at the U.S. Commodity Futures Trading Commission.
Small firms suffered the biggest losses to high-frequency traders on each contract traded, according to the study co- authored by Andrei Kirilenko, the agency’s chief economist, who is leaving this year. High-frequency traders collectively earned $23 million in trading profits in the E-mini S&P 500 futures contract in August 2010 according to the study posted on the National Bureau of Economic Research website.
“The profits appear to be quite persistent and made by a small number of participants,” Kirilenko said in a telephone interview today. “The most aggressive participants, those who take liquidity, seem to be most profitable.”
The paper, which defines small traders as retail participants, doesn’t represent the official views of the CFTC, the main U.S. derivatives regulator.
The CFTC, with the Securities and Exchange Commission, has scrutinized high-frequency and algorithmic trading since May 6, 2010, when $862 billion in equity value was erased in 20 minutes before share prices recovered from the plunge. The agency has been drafting a document called a concept release, a step prior to a formal proposal of new rules, that may recommend registration of high-frequency firms.
“What this paper shows is that this type of speed trading can often be parasitical and have far less value to markets and price discovery than many contend,” said Bart Chilton, one of three Democrats on the CFTC.
The study examined 65 firms that trade a large number of contracts, keep a consistently low inventory level and typically don’t hold positions overnight. The study identified 14 “aggressive” HFT traders who initiate most of their trades and take liquidity from markets, 21 “passive” traders and 30 mixed.
“There well may indeed be HFTs who are liquidity providers, but there are some who are very clearly not,” Kirilenko said.
The study found that aggressive HFTs made $3.49 per contract traded with small traders, while passive traders made $5.05 on the same type of transaction. They made less trading against each other or against non-HFT companies that make markets or institutional traders.
High-frequency trading firms earn most of their overall profits from medium-sized traders who take large directional positions in markets, the study found.
“Small traders, the way we characterize them, lose money to all other categories of traders, not just HFTs,” Kirilenko said in the interview.
The study should be considered alongside others that have demonstrated improvements to market quality stemming from high- speed trading strategies, said Jim Overdahl, vice president at NERA Economic Consulting and an adviser to the Principal Traders Group at the Futures Industry Association.
“It’s important to keep in mind that there are a variety of studies out there that are focused on modern electronic markets that have looked at the market quality improvements that have occurred over the last five to 10 years,” Overdahl said in a telephone interview. Participants in markets “have altered their trading strategies so that they’re not at a disadvantage,” he said.
The principal traders group represents more than 30 firms including Getco LLC, DRW Holdings LLC and Quantlab Financial LLC.
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