When defenders of High-Frequency Trading (HFT) argue that they’re providing liquidity to markets, it always makes us grimace. The main reason for this is that we often hear the same argument made to defend speculators in the futures trade (and often make the argument ourselves) and we’re not thrilled that one of the most hated groups of market participants is using our logic to defend themselves, too. After all, the hostility toward HFT has already prompted some countries to push ahead with plans for a financial transactions tax… that’s not something we want to be associated with.
So as we were reading over this piece from Naked Capitalism, one section really jumped out at us – it was a quote from former Goldman derivatives expert Wallace Turbeville, explaining the different ways that market participants can impact liquidity. He goes so far as to argue that some kinds of trading behavior add liquidity, while others can actually take it away:
The article starts by defining three types of traders: Value Investors (even momentum investors who operate on longer timeframes than HFT types can wind up being Value Investors), Market Makers and Information Traders (HFT and algos). As Turbeville explains:
“It is obvious that a market participant is a liquidity provider only if the prices he or she quotes can be relied upon by other market participants, specifically Value Investors and those Information Traders who at the time are acting as liquidity takers. A price quote that appears on a screen is useless as a source of liquidity if it is not available when it comes time to transact. An Information Trader provides meaningful liquidity when his or her quoted prices represent levels that are reliable and meaningful to the participants who are liquidity takers. Sometimes an Information Trader provides such quotes and sometime it does not. When it is active, but not providing such quotes, it is a liquidity taker..”
When it comes to the kind of speculators we’re working with – CTAs – most have long enough time frames for their trades that they would probably fall into the “Value Investor” category. But even those who are making buy and sell decisions on shorter time frames (the true Information Traders) can add liquidity, as long as their quotes are real and reliable. In Turbeville’s view, rapid-fire order cancellations that flood the market with “fake” liquidity actually detract from the smooth functioning of the market.
The whole Naked Capitalism article is a great piece that draws on quite a few people’s thoughts on HFT, and is definitely worth a read. But the most important takeaway in our minds is that not all liquidity is created equal, and not all traders are necessarily “adding liquidity” with their participation.