Diary of a Financier

Followup: Equity Futures Displacing Cash Markets (via HFT)

In Capital Markets on Tue 20 Mar 2012 at 18:07

I’ve talked a lot about the distorting potential of both High-Frequency Trading (HFT) and S&P 500 E-mini Futures (ES/). In May 2011, I fully discussed my concerns about ES’s displacement of cash markets like the actual S&P 500 Index (SPX) and its underlying stocks. More recently, I also revived my discussion of HFT. This update closes the loop by tying ES to HFT.

Before the NASDAQ and electronic exchanges, guys in my business used to broker client trades with more than a point in commission built-in. The wide bid/ask spreads of open-outcry exchanges enabled this industry [mal]practice. For example, General Electric (GE) traded 17.25 x 18.00, so they were able to buy at the bid, add the point, passing on a cost to the client of $18.25 (17.25 bid + 1.00 commission). Since then, technology has reduced equity trading spreads to 1 cent or less. Suddenly, arbitrageurs have been reduced to picking up pennies where there once were dollar-bills–a game too quick and precise for mankind. Hence, the rise of the HFT machines.

Looking at chart overlays of ES and cash markets like SPX & SPY, this dynamic is clearly illustrated. First, notice the migration of Open Interest & Volume from the regular-sized SP futures contract to the mini ES:

SP & ES- Open Interest leaving SP for ES.

Acknowledging that growth in ES utilization, understand that the value of futures contracts correlate to their index because arbitrageurs pounce on the slightest of disclocations in the relationship. If the actual SPX lags the ES, an arb buys a basket of SPX constituent stocks and shorts ES to capture the inevitable recoupling opportunity. With that in mind, note the increase in correlation (and reductions of correlation deviation) between S&P 500 futures and the actual index over the past decade:

ES v SPX- increasing correlation has eliminated arbitrage opportunities, eroding the utility of futures contracts for non-HFT traders.

By virtue of that tightening correlation, human traders cannot pounce on arb opportunities quick enough anymore. The task is left to HFT robots, which have almost entirely displaced trading volume from humans (as equity fund flows are a testament). Further, assembling a basket of actual SPX stocks is too clunky a task, so naturally HFTs have turned to the liquid S&P 500 ETF (SPY) to fulfill that leg of their arb trades. The following charts of ES v. SPX (top) and ES v. SPY (bottom) shows how the tracking error against SPX (correlation >0.992) grew too thin for arbs this past decade, so opportunists began focusing on SPY in 2004-06 (correlation <0.97):

There’s the manifest evidence. I’ve covered the consequences ad nauseum in the aforementioned entries. Regulators must distinguish between commercial and speculative participants in equity futures contracts, then overhaul margin/position requirements accordingly. The CME refers ES to the SP contract specifications regarding position limits, which establishes a maximum of “20,000 [contracts] net long or short in all contract months combined” or $1.4b as of today’s SPX close ~1400. Like in most commodities futures markets, equity futures traders who are commercial hedging should have a higher maximum than speculators. Otherwise, we’ve lost sight of equity futures’ real purpose as a hedging mechanism.

I could frankly let this all slide if regulators just addressed HFT robots. Perhaps, limit these computers to gross intraday trading limits equal to their capitalization (or some low multiple thereof). They certainly must move off the exchanges. My, my, I could go on forever…

–Romeo

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