In a new report, the New York Federal Reserve says that high frequency trading (HFT) has “enhanced market efficiency” in the foreign exchange markets.
Measurable arbitrage opportunities decreased as HFT was popularized
“Data (from the study) is certainly consistent with a view that the rise in algorithmic and High Frequency Trading enhanced market efficiency as measured by the availability and persistence of pricing arbitrage opportunities available in the FX spot market,” wrote the report’s author, Ernst Schaumburg, a research officer in the New York Fed’s Research and Statistics Group.
Schaumburg noted that little research has been done on the FX markets, the deepest and most liquid markets in the world with average daily volume near $2 trillion. The FX markets are currently the subject of a market rigging scandal as Bank of England Governor Mark Carney is facing charges that he was aware of market manipulation for more than eight years.
Activity concentrated among large FX dealers
“While there’s a broad diversity of players in the FX spot market—including corporations, official institutions, and pension funds—the latest data show that activity is most concentrated among the large FX dealers and other financial institutions,” Schaumburg wrote. Unlike centralized derivatives markets, where a limited number of exchanges trade various contracts, the FX markets are managed through a process where the brokerage firm can act as the exchange, and there are literally hundreds of different venues in which to place orders.
“High Frequency Trading, principally market-making and arbitrage strategies, represents a subset of algorithmic trading that features trading and order submission strategies that involve extremely high rates of order submissions, modifications, and cancellations carried out using autonomous computer algorithms that react to incoming market signals within milliseconds,” Schaumburg wrote, failing to differentiate between directional high frequency trading strategies and two sided market making activities. “While the impact of these types of strategies on the equities and futures markets has received a lot of attention, especially after the “flash crash,” the impact of these strategies on the FX spot market, which has a far different structure, has received less attention.”
High frequency trading: Less available arbitrage opportunity equals more efficient markets
To make his point that high frequency trading improves market efficiency, Schaumburg considers the availability of arbitrage opportunities. He makes the assumption that the less price arbitrage opportunities between different FX markets there are available, the more efficient the markets, a commonly acknowledged belief.
Schaumburg then sets up a trade scenario from 2007 illustrating how markets were inefficient, each carrying momentary price differentials that enables a spread arbitrage opportunity to buy in one market and sell in another. This sets up a consideration of Triangular-Arbitrage opportunities. Schaumburg notes that the existence of such Triangular-Arbitrage fell significantly with the onset of high frequency trading and have essentially evaporated.
“This pattern is consistent with the timing of the emergence of high frequency trading and algorithmic trading enabled by application programming interfaces provided by electronic trading platforms to facilitate automated trading,” he wrote. “Interestingly, the financial crisis in 2008-09 had relatively less impact on the efficiency of FX markets relative to other markets such as fixed-income and structured finance, which saw significant dislocations and seeming violations of no arbitrage amid funding and liquidity problems.”