They face the same set of risks as the HFT market-maker – inventory and information risk. But persistence and fat tails in short-term price movement amplify these risks. From equation (1), the greater the holding period, T, the greater the potential dispersion in future prices. Intuitively, with fat-tailed persistence, a large shock is both more likely and its effects will linger longer. Slower trading increases the distance prices can travel once de-anchored. Chart 12 illustrates this. The distribution of returns observed at a low frequency has far greater variance and kurtosis than that at a higher frequency. For example, the variance of prices faced by a LFT firm (trading at T=50) is around nine times greater than for a HFT firm (trading at T=1), for H=0.9. 23 Given these price dynamics, HFT aggravates the market-making problem for LFT firms by magnifying the market risk they face. 24 And it is not just that LFT firms are slower to execute. In situations of stress, they may not even be able to see the prices at which they can trade. Co-located traders may have executed many thousands of trades before LFT firms have executed their own. LFT firms face intrinsic uncertainty about prices. When volumes and  21  Clark (2010). 22  CFTC-SEC (2010). 23  Even once an adjustment has been made for the degree of time scaling associated with a standard Brownian motion. 24  Indeed, with fractal price dynamics the variability of prices will potentially grow without bound over time.

The race to zero may have contributed to those abnormalities, adding liquidity during a monsoon and absorbing it during a drought. This fattens tail risk. Understanding and correcting those tail events is a systemic issue. It may call for new rules of the road for trading. Grit in the wheels, like grit on the roads, could help forestall the next crash. 14  BIS central bankers’ speeches  References Aldridge, I (2010), “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems”, Wiley Publications. Arestis, P and Demetriades, P (1997), “Financial Development and Economic Growth: Assessing the Evidence,” The Economic Journal, Vol. 107, No. 442 (May, 1997), pp. 783–799, Blackwell Publishing for the Royal Economic Society. Automated Trader Magazine (2010), “What just happened?”, Issue 18(3), available at: http://www.automatedtrader.net/articles/risk/50335/what-just-happened. Bouchaud, J, Farmery, J D and Lill, F (2009), “How markets slowly digest changes in supply and demand,” Santa Fe Institute working paper. Blackledge, J (2008), “Application of the fractal market hypothesis for macroeconomic time series analysis,” ISAST Transactions on Electronics and Signal Processing, Vol. 1(2), pp. 89–110. Brogaard, J (2010), “High frequency trading and its impact on market quality”, mimeo. CFTC-SEC (2010), “Findings regarding the market events of May 6, 2010”, Report of the staffs of the CFTC and SEC to the joint advisory committee on emerging regulatory issues, September 30. CFTC-SEC Advisory Committee on Emerging Regulatory Issues (2011), “Recommendations regarding regulation to the market events of May 6, 2010”, available at: http://www.cftc.gov/ucm/groups/public/@aboutcftc/documents/file/jacreport_021811.pdf.