Autocallables, Mifexit and the value of HFT

The week on Risk.net, September 19-25, 2020

7 days 240920

Autocalamity: can hit product be reinvented?

Spreads on ‘worst-of’ bonds leap 50% as some dealers retreat and others pile on hedges

Hedge funds eye Brexit escape from Mifid reporting

UK tipped to diverge from Europe’s proposed reforms to fund manager rules

Don’t blame HFT: plug liquidity gaps for market stability

Dynamic fees could incentivise liquidity when and where it’s most needed, writes quant fund founder Bouchaud


COMMENTARY: High-speed trading may still be a drag

The debate over the value of high-frequency trading (HFT) continued on Risk.net this week, with Jean-Philippe Bouchaud, founder of quant fund Capital Fund Management, arguing that many of the common criticisms of HFT are ill-founded.

HFT has been blamed for ‘flash crash’ events. Whether or not this is true of episodes such as the 2010 crash, Bouchaud says, sudden drops in markets have been happening since long before HFT existed – there was one in 1962 – and in general there is no evidence that volatility has increased since HFT came into the markets at a significant level.

Market participants have long complained that the liquidity provided by HFT is evanescent – it vanishes when it’s needed the most. But this is true of all liquidity, whether provided by human traders or algorithms, Bouchaud counters.

And he points to the compression of bid-ask spreads as an unquestionable benefit of the HFT boom. With US equity bid-ask spreads now three or four basis points, rather than 60bp before 1980, “investors were paying a much higher price for liquidity before HFT”, he says.

But there are still a few reasons to doubt HFT’s value. Bouchaud argues that a destabilising loop exists – volatility leads to higher spreads and lower liquidity, which leads to more volatility. The reverse doesn’t seem to be true, though – by his own argument, although spreads have been crushed down dramatically by HFT, volatility hasn’t really moved.

The second point is a more fundamental one about the cost of liquidity. On a per-transaction basis, no doubt, the cost is lower – much tighter bid-ask spreads make that inevitable. But the other side of the equation is that high-frequency trading has meant, well, a higher frequency of trades. Since 1980, US equity spreads have dropped to a few percent of their former levels, as Bouchaud says, but over the same period, US annual traded equity volumes have risen twenty-fold.

Multiply those together, and has the overall cost to the market of providing liquidity – the spread per transaction multiplied by the volume of transactions – really changed so dramatically? Tighter spreads are nice to have for the individual investor, but the economic cost of operating the equity market as a whole may not have dropped quite as far as they might suggest.

The point of an equity market, economically, is to allocate capital to the places where it can most efficiently be employed. The profit of the market-makers and other participants is the unavoidable cost of making that happen, not the reason for the market’s existence, any more than supermarkets exist for the benefit of their trollies. It’s fair to ask whether HFT has made equity markets better in this sense.

And, as Risk.net has discussed before, there are other worries about HFT. Concerns around opacity persist, and led one bank to kick out many of its HFT clients just last year. Use of HFT has brought unprecedented levels of concentration – and concentration risk – to many markets. A sufficiently large HFT presence not only turns a market into an inefficient oligopoly: new entrants will be hard-pressed to find the hundreds of millions of dollars in technological spend to match the established players; and it also creates a few points of failure, any of which would be catastrophic.


STAT OF THE WEEK

From March to August, monthly bond trading volumes averaged $821 billion in the US, 27% higher than the 2019 monthly average. Over that time, the share of US bond trading activity on the two main e-trading platforms, MarketAxess and Tradeweb, has leapt by seven percentage points, reaching an all-time high of 35% in August.

 

QUOTE OF THE WEEK

“I have conversations with Italian clients, German clients, UK clients, and they’re all starting to make allocations into Chinese bonds for the first time. There is a huge amount of activity going on. In our fund, we used to just have US dollar and euro hedged into CNY. Now we’ve got sterling, Swiss francs… For these other currencies, people have started to convert their foreign currency to CNY and invest in the Chinese bonds market for the first time” – Hayden Briscoe, UBS

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