An apparent paradox may have emerged in market making: bid-ask spreads and aggregate profits from market making have declined but aggregate profits from high-frequency trading (HFT), have increased. Brattle principals Paul Hinton and Michael Cragg recently co-authored an article for the January 2015 issue of Financier Worldwide that discusses how the technological evolution of the U.S. equity market’s microstructure and competitive forces may have combined to produce this paradox, the implications for market performance, and the dilemma this poses for regulators.
With HFT now exceeding 50 percent of the U.S. trading volume for listed equities, many wonder whether or how the U.S. Securities & Exchange Commission (SEC) will strike a balance on HFT regulation. In June 2014, SEC Chair Mary Jo White announced the formation of the Market Structure Advisory Committee to review specific initiatives and rule proposals. Her speech provided support for the proposition that order execution costs have decreased as a result of the market structure developments of recent years. Despite this announcement, the authors argue that algorithmic market making and HFT have created fragility and execution risks due to aggressive trading and order anticipation strategies, which should not be ignored. The aggregate facts about increased market quality selected by the SEC Chair do not capture the implications of the dramatic change in market structure for many participants. Promoting competition between HFT firms may not serve to improve market performance but instead encourage socially undesirable rent seeking and raise the infrastructure costs of trading perhaps creating a winner-take-all environment.
The article is available for download below.