Feb 8, 2023
‘Flash Boys’ Improve $7.5 Trillion Currency Trading, Watchdog Says
(Bloomberg) -- High-frequency traders are often singled out as the culprits behind a lack of prices when markets get jumpy.
But the activities of these controversial companies have gained a stamp of approval from the UK’s regulator, at least in currency markets. According to a new study published by the Financial Conduct Authority in January, computer-driven trading firms are better at handling a pick-up in volatility than banks and contribute the “dominant” share of new information into exchange rates.
“It turns out that HFTs’ price-changing limit and cancel orders contribute nearly half of overall price discovery,” the study’s authors wrote in a paper. “On average or during normal market times, we find HFTs provide better order-book liquidity than dealers,” the authors added.
The rise of these computerized trading firms, chronicled in Michael Lewis’s book “Flash Boys”, has led them to take a growing share of deals in the $7.5 trillion-a-day global foreign-exchange market. Two such companies were named in the top 10 largest players in the industry’s benchmark market share survey by Euromoney.
Their rise has been helped by post-crisis regulations hampering banks’ ability to take on risk and in turn, the ability to provide prices at all times. Artificial intelligence and machine learning are likely to add fuel to the trend in future.
For the FCA study, Wenqian Huang, Peter O’Neill and Shihao Yu analyzed currency data from London Stock Exchange Group Plc’s Refinitiv platform, looking at sterling and Australian dollar transactions against the US dollar from 2012 to 2015.
The paper also found that when volatility in equity markets picks up and the VIX Index surges, the HFT trading firms widen the gap between the prices they’re willing to buy and sell specific currencies, but significantly less than banks do.
“HFTs’ order-book liquidity is less sensitive to volatility spikes: in response to a large and positive impulse of stock-market volatility index (VIX), HFTs’ bid-ask spreads increase by about 1%, which we find is only half of the response by dealers,” the study concluded.
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Unlike equity markets, currencies operate under a two-tier structure, with large dealers and recently HFTs trading against each other in a process known as price discovery. End-clients and corporates get a derivative of these rates in the so-called dealer to customer market.
While banks have a broad network of clients they provide prices to, HFTs tend to only trade in wholesale markets rather than directly with customers. The FCA’s study found that HFTs help with the smooth functioning of both wholesale and retail markets by ensuring dealers have access to liquidity when banks and their clients need it.
“[The results] indicate that, beyond order-book liquidity provision, HFTs contribute to market liquidity in a broader sense by passively absorbing the pricing errors created by dealers’ liquidity demands,” the study’s authors said.
Still, the study concluded that banks do better around scheduled data releases and macroeconomic events than HFT peers, which the authors ascribed to their large network of clients and customers. Corporates and investors position for such events, which gives banks an edge as they have access to “private” information that HFTs don’t have.
This means that while HFTs tend to pull back from price provision “significantly” ahead of key data releases such as US non-farm payrolls numbers by widening their bid-ask spreads by about three times as much as banks, dealers hoover up business and step into markets as primary liquidity providers in these periods.
“The above results suggest that dealers and HFTs may specialise in managing different types of information asymmetry in their market-making,” the study said. “While HFTs contribute more to price discovery through their active quote updates, incorporating public information, dealers contribute more through their trades, incorporating private information.”
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