In the trading room section of the Financial Times (registering required), journalist Jeremy Grant asked for an industry insider to throw some light on High Frequency Trading. Several traders responded, but the award for explaining HFT in an easy way was won by IMC. It’s not exactly rocket science, but one must admit they succeeded in explaining the matter in layman’s terms.
Here’s Robin van Boxsel, Remco Lenterman and Tim Edwards from IMC:
“Essentially, a market maker provides liquidity, which we believe is positive within financial markets, if not a fundamental condition of them. Speed is an essential tool for market makers to manage risk by controlling the amount of time that their quotes are placed on an exchange. This is commonly referred to as exposure time.
For every quote in the market that a market maker provides, they are exposed to that quote for the time it takes for a cancellation to be processed, or the time it takes to remove the exposure following a market move or a move in a related instrument.
Basically the higher the speed, the lower the time between when information is received and the time when such information is incorporated into prices. For any given order, the value of this fraction of a second exposure is very low. However, across an entire market venue, this adds up to very large numbers.
In the cases where exchange speeds are high, it enables market makers to manage their risk better and therefore they are willing to quote narrower spreads and for bigger size. The relationship between speed, spread and liquidity is evident on many exchanges and clearly adds value to all participants.
It is clear that in the past 10 years, major markets have become substantially more liquid with narrower spreads and lower transactions costs. Speed has played an essential role in this development.
A case in point is that markets that continue to have slow systems and/or low bandwidth have very little displayed liquidity (Hong Kong, Australia, Osaka Stock Exchange) and that in order to facilitate increased liquidity, they need to change these systems, which is happening.
The role of an exchange is to supply a venue for buyers and sellers to access securities. This is the core of capital formation, spreading risk from those who cannot bear it to those who seek it. Market makers even out the distribution of risk through portfolio management, and give liquidity where there is not a natural counterparty. Exchanges are providing exactly the service we expect of them by increasing speeds and lowering order acknowledgement times, aiding market participants to provide the liquidity we expect to be available in a market centre.
We hope we have been able to shed some light on this subject.” (pdf)