Contrary to popular belief, high frequency trading reduces volatility in stock markets rather than exacerbates it, according to new research by Professor Alex Frino at the University of Sydney Business School and CEO of Capital Markets Co-operative Research Centre.
Working with a number of global exchanges including the Nasdaq, Euronext Paris and the London Stock Exchange, Professor Frino said there was no evidence of a relationship between an increase in high frequency trading and price volatility in equity markets.
"If high frequency traders (HFTs) exacerbate volatility, you expect to see a positive relationship between an increase in high frequency trading and an increase in price volatility and we've estimated this relationship for quite a few markets around the world - equities markets - and find rather than a positive relationship, we find actually a negative relationship," Frino explained.
"At face value that implies that HFT rather than exacerbating volatility in fact improves volatility," he added.
Despite many of the exchanges Frino worked with profiting from higher volumes generated by high frequency trading, he rejected the suggestion that these so called "vested interests" had influenced his findings, pointing to financial regulators who had also participated in the research.
"Our partners are also regulators who make no money from trading volume, the Financial Services Authority (in the UK), the Securities and Futures Commission in Hong Kong hardly make money out of volume," he said.
High frequency trading has been blamed for a number of market sell-offs, most recently in August, where some global exchanges recorded their worst percentage losses since 1998, but Frino said blaming high frequency trading for market volatility was overly simplistic and based on "hearsay and opinion".
A 'Major, Major Negative'
Frino points out that a function of HFT algorithms is to recognize when prices are abnormally high or low and their responses to it push prices back towards equilibrium, thus calming markets.
But critics argue high frequency trading leads to more correlations, making it more difficult to diversify with index-tracking or exchange-traded funds, and floods markets with "false" liquidity.
Marvin Schwartz, Managing Director of Neuberger Berman, told CNBC earlier this month that "high frequency trading is a major, major negative for the stock market, it's a major negative for the economy, it doesn't do anything for the economy, it doesn't add any value to the economy."
Frino concedes that some types of high frequency traders could have an exacerbating influence on uneasy markets.
"There are different categories of high frequency trading: there are market makers who make two-sided markets and provide liquidity, I don't believe that they in any way could exacerbate volatility," he said.
"Then there's the position-taking high frequency traders who in essence take bets on the market and a portion of those look for mean reversion, they try and identify extreme price movements and trade against them because they believe the price is going to revert back to an equilibrium level, and of course then there's group of high frequency traders that some people call 'scalpers' and they could potentially exacerbate volatility," Frino said.
"Unfortunately we're not able to break down the pool of HFT trading into the different styles…the net pool and its net impact on volatility is not a negative one," he added.