As a professional trader, you are confronted daily with all kinds of dynamics and situations that require a flexible and adaptive mind. You are faced with multiple variables constantly interacting with each other and your task is to process ever-changing information quickly and profitably. Valuations arbitrage, reflexive supply-and-demand dynamics, and structural changes are recurrent landmines in the typical day of traders and money managers.
We accept this “dangerous” line of work for only two reasons: monetary compensation and pride in being part of capital markets, that transmission mechanism without which innovation and creativity would be prisoners of their own ethereal state.
As a society, we are ready to strike compromises in return for a system that will allow the ethereal state of our creativity to turn into reality. We allow market insiders like market makers, broker-dealers, and others to have small advantages over us mortal investors in order to have them create the positive externalities that help us build a more sophisticated economic system. We give market makers and specialists a privileged look at the order flow (the supply and demand of stocks) in exchange for their commitment to maintaining orderly markets whenever an imbalance occurs. We give systemic firms like JP Morgan and Goldman Sachs privileged access to liquidity via the Federal Reserve so that the banking system and capital markets can continue to serve us in our quest to invent, produce, and distribute new products.
But sometimes things turn out more like a bad inland casino rather than a better market…
We may still be reeling from the systemic economic collapse of last year, but new structural changes with potential negative externalities are already at our door.
For months I have witnessed strange dynamics in the way markets behaved: liquidity issues, intra-day volatility, and a constant disconnection between technical, sentiment and fundamental inputs. Markets often go through periods of irrationality, but this time it felt different.
As a professional trader and an educator on markets, my sensitivity level is higher than normal and I immediately began conducting research to make sense of my discomfort. This process pointed consistently to one element: high frequency trading or as I like to call it “the rise of the machines.”
What is High Frequency Trading?
High frequency trading (HFT) was, until recently, a topic confined to Wall Street insiders. Only in the last few weeks has it become a mainstream subject of debate via articles on the New York Times, the Washington Post, and interviews on CNBC (yes even CNBC’s clueless anchors can now spell HFT).
The reason for this foray into the mainstream media is the potential negative ramifications HFT can have for all of us: investors, entrepreneurs, and just plain hopeful citizens.
But first, let’s define HFT as it is a very technical classification that, nonetheless, encompasses many different things. Generally speaking, HFT is high velocity trading based on mathematical algorithms that create huge daily volume on different electronic exchanges and platforms. It is machine against machine—endless trading in order to capture fractions of pennies in profits. But, so far so good: the machines provide liquidity to all of us. The owners of the machines (financial institutions) make an all-American profit and the liquidity aggregators (electronic exchanges) provide competition to other exchanges in the most capitalistic way.
But what happens if we scratch the surface? Like Michel de Montaigne, the famed Renaissance scholar, once said: “There is no man so good, who, were he to submit all his thoughts and actions to the law would not deserve hanging ten times over.”
High frequency algorithmic trading is ridden with issues:
- Volume. Machine-driven trading is over 60% of trading volume on a daily basis and in some confined cases it can be as high as 90%.
- Adaptability. Machines are unthinking units that do not adapt to human reactions. HFT algorithms are based on correlations and historical relationships, which are great guidelines for trading and investing but by no means they can be used blindly (see: 1987 portfolio insurance, long-term capital management 1998, credit default swaps 2008, mortgage-backed securities 2008…the list of quant-related disasters is a sad one).
- Exclusivity. HFT can only work by using incredibly fast and powerful computers that also must be placed in the exchanges as proximity helps the speed. Few people can afford the computers and/or the co-location fees charged by the electronic exchanges.
- Flash quotes. Some brokers have access to quotes of orders before anyone else. By exploiting the speed of their machines, they can either arbitrage price differentials or potentially front-run clients. Another abuse of flash quotes (called flash because they last one–to-three milliseconds) is that they can be used as teaser quotes to gauge supply and demand without the risk of being hit due to their quickness.
- Rebates. Many high frequency traders trade not for profit but for rebates paid by the electronic platforms to attract liquidity. This escamotage incentivizes useless and toxic volume.
While these are only the most immediate concerns about HFT, they have a potentially disproportionate influence on the cost of running our capital markets. The HFT lobby pushes the argument that they create positive externalities by exploiting improving technology—but there is a difference between volume and liquidity.
If over 60% of trading is toxic, it will go away in a nanosecond and most likely it will dissipate right when investors and money managers need it the most. This could cause a huge liquidity vacuum and a 1987-type of event. Liquidity is created by market players with a stake in the game, not by casino-like machines. Flash quotes and “predatory algorithms” also raise the cost of execution for the necessarily slower institutions like pension funds and mutual funds. Additionally, the surreal tempo of machine trading makes trading for all more expensive as we now have to prepare for the irrational moves and volatility of markets when executing our trades.
I love this business and I love technology, but checks and balances are needed to preserve our capital markets.
Little adjustments can be made to reduce systemic risk, like re-instating circuit breakers that cut off program trading when price changes accelerate beyond certain parameters, like investigation or stopping flash quotes that drive front running, like making good on teaser quotes for longer than just three milliseconds, and so on. In the end, we need to understand that capital markets are here not to destabilize our economy, but to serve us as a society and help us make better lives.
Paul Wilmott, “Hurrying Into the Next Panic?” The New York Times, July 28, 2009.
Tobin Harshaw, “Is Wall Street Picking Our Pockets?” The New York Times, July 24, 2009.
Sal Arnuk and Joseph Saluzzi, “Toxic Equity Trading Order Flow on Wall Street,” white paper, Themis Trading LLC.
Related in the GBR
Is Managed Futures an Asset Class? by Davide Accomazzo, MBA, and Michael “Mack” Frankfurter
Examining the Role of Short-Term Correlation in Portfolio Diversification by Jeffry Haber, PhD, and Andrew Braunstein, PhD
The Buffett Approach to Valuing Stocks by Steven R. Ferraro, PhD, CFA