research - Has high frequency trading (HFT) been a net benefit or cost to society?

Various studies have demonstrated the very large and growing influence of high frequency trading (HFT) on the markets. HFT firms are clearly making a great deal of money from somewhere, and it stands to reason that they are making this money at the expense of every other participant in the market. Defenders of HFT will argue that HFT firms provide an essential service to the economy in the form of greater liquidity.

What research has been done on the benefits and costs of HFT? Has any study attempted to measure either the benefits or the costs? How would one attempt to measures these benefits and costs? What would be the effect of banning rapidly cancelled limit orders (see follow-up question), e.g. via a minimum 1-second tick rule?

Any references and professional opinions (backed by research) on this topic would be appreciated.

Answer

The lead paper in the January 2011 Journal of Finance (Hendershott, Jones, and Menkveld) addresses algorithmic trading (AT). In short, they find that AT improves liquidity as measured by bid-offer spreads. Taking the econometrics as correct (it is in the Journal of Finance) the next question is if bid-offer spreads are a sufficient statistic for measuring liquidity (or any other benefits).

It is a difficult question to answer because, given current market structure, AT may improve liquidity (as measured by bid-offer spreads), but without data on other market structures, it is hard to say that we wouldn't better off with something like on-demand call auctions. I think there's a consensus that opening and closing call auctions have improved market quality as measured by opening and closing volatility, but it is not clear that we'd be better/worse off with completely call on-demand exchanges (although I know of at least call on-demand exchange in the works).

I think at this point it's still a subjective question with smart people on both sides. I tend to think we'd be better with call auctions (in terms of the pure economics of matching supply and demand). Finally, you may find this Big Picture post interesting.