Yes, Virginia, HFT and Liquidity are Not All They Are Cracked Up to Be

You may have seen a big outbreak in the academic literature and business media of defenses of liquidity for liquidity’s sake, evidently prompted by increased interest in and in the EU, implementation of transaction taxes as a way to tame speculation and secondarily raise revenues.

And other efforts to curb market manipulation are underway. For instance, the SEC and the FBI are joining forces to try to rein in predatory HFT, but are finding it an uphill battle due to the fragmentation of information:

Even with these impediments, however, people who are knowledgeable about HFT practices can describe how it is in fact detrimental. A useful piece by former Goldman derivatives expert Wallace Turbeville explains in depth why it is extractive. Some analysts have suggested that HFT is destructive in volatile markets by withdrawing activity when it is most badly needed, but adds liquidity in normal markets. Turbeville debunks the idea that it plays a positive role even when markets are functioning normally.

A big reason for Turbeville’s clear, negative reading is that (mirabile dictu!) he defines the purpose of financial intermediation as facilitating real economy activity. From the start of his article at Demos:

The prior article in this series points out that the most important social purpose of the financial markets is to facilitate the movement of funds from (a) holders that seek investment opportunities to (b) businesses and governments who need to put investment capital to work in productive ways and to individuals who seek to borrow for their current needs. This function is referred to in this series as “Capital Intermediation.” The article describes findings that the cost of Capital Intermediation has increased significantly over the 35 years of financial market deregulation in the United States, despite advances in information technology and quantitative analysis that intuitively should have increased efficiencies in the process. Instead, Capital Intermediation has become less efficient.

The article starts by defining three type 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).