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HFT is Insatiable - its Hidden Costs

Requires expensive capacity increases, puts the market at risk every minute of every trading day

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We have spent the last 24 years working with real-time market data on a tick-by-tick basis. We monitor our commercial datafeed in real-time to stay on top of market changes or issues. This past year, we have spent considerable time and effort studying the relentless growth of equity quotes. Based on our findings, virtually all of the additional quotes contribute zero or negative economic value to stock pricing, because they are either way outside the market or end up expiring before any investor or trader could possibly act on them. Furthermore, we can't find any self-limiting mechanism in place that will ever put a stop to this unnecessary and expensive growth of misinformation. The only thing that prevents a sudden explosion in quote traffic is the capacity limitation set by SIAC which runs the Consolidated Quote System (CQS) for the exchanges.

Every 3 months or so, SIAC increases the capacity limitation for CQS. Shortly after each increase, often the next trading day, quote rates will surge to new record levels and completely fill the new capacity. The chart on the right beautifully captures this phenomenon: it shows the 2 ms peak quote rate for CQS on 30 minute intervals over each trading day since July 2010. Recent dates are colored towards the red end of the spectrum: older dates towards the violet. The gaps between groups of lines chronicle the immediate jump in quote traffic after the capacity limit is raised. The gap between the green and orange groups occurred after the limit was raised on July 5th: traditionally one of the quietest trading sessions of the year. The lone green line near the 600,000 level marks the only time when it took more than a day to hit the new limit. See if you can distinguish between the quiet trading days of July and the tumultuous trading days of August among the orange group.

When CQS capacity fills, new stock quotes are placed in a queue to prevent loss. In a trading environment running at the speed of HFT, most of these quotes will end up expiring before exiting the queue. In effect, when quote traffic is high, most of the additional quotes will be canceled long before a trader or investor receives them. And quote traffic is often highest when reliable information is most important.

Extra capacity is vital for times of market stress from surprise news events or shocks to the system. The lack of capacity during these times will quickly lead to a drop in liquidity as traders pull out from lack of clear pricing information. This was a major cause of the flash crash.

We understand that market makers and HFT need to adjust their quotes to fast changing market conditions. But 10,000 times per second per symbol, or more, in an inactive stock? Every quote has a non-zero cost: millions of computers and miles of network cables must process and transport each one, costing both time and energy. Sending quotes and then canceling them before they ever leave the exchange network is absurd.

We think we found a possible solution to the HFT/non-HFT divide that lets the market itself decide the value of an equity quote. The solution is incredibly simple and has virtually zero impact on the millions of systems already in place. It also requires no cancellation fees or transaction taxes, and it lets trading go as fast as the speed of light.

Stay tuned.

The chart below shows 2 ms peak quote rates on 1 minute intervals, illustrating just how often capacity limits are hit.


Publication Date: 10/14/2011

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