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Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

Could Speed-of-Light Market Trading Trigger The Next Systemic Crisis?

Stock-Markets / Financial Markets 2012 Aug 06, 2012 - 02:20 AM GMT

By: DK_Matai

Stock-Markets

Best Financial Markets Analysis ArticleComputers don't sleep, don't get tired, don't care about politics and don't go on holiday in August -- but they can wreak havoc in the global financial marketplace by amplifying moves on the up- and down-sides as we recently saw with the "Dark" Knight fiasco involving 140 stocks listed on the New York Stock Exchange of which nearly 40 moved more than 10% in less than an hour.  The "Knightmare on Wall Street" has cast new doubts on the automated High-Frequency Trading (HFT) systems that now totally dominate global exchange trading, despite multi-million-dollar lobby groups proclaiming from rooftops that HFT is not only safe and stabilising but beneficial to humankind.  Powerful algorithms -- “algos” in industry parlance -- execute millions of orders per second and can scan dozens of public and private marketplaces simultaneously. They can not only spot trends before other investors can blink, changing orders and strategies automatically within milliseconds, they can also choreograph and co-ordinate strategies across geographies and asset classes. 


Isn't it truly worrisome that financial trading at the speed-of-light is beyond the capacity of humanity to control during a crisis?  Has the toxic combination of price momentum-based High-Frequency Trading strategies and the proliferation of leveraged Exchange Traded Funds or ETFs served to launch the newest forms of weapons of wealth destruction and are they together alienating legions of frightened investors?  "This is where all the money is getting made," according to William H Donaldson, former chairman and chief executive of the New York Stock Exchange. "If an individual investor doesn’t have the means to keep up, they're at a huge disadvantage."  In effect, we have moved towards a two-tiered global financial marketplace consisting of the high-frequency arbitrage players garnering 'first class' travel access and privileges whilst everyone else has been relegated to 'economy class' status.

Harmful Effects of Oligopoly & Oligarchy

High-Frequency Trading has become a dominant force in global financial markets, accounting for over seventy percent of dollar trading volume in the US alone. What are the implications of High-Frequency Trading for stock price volatility and price discovery? Pioneering research by Prof Frank Zhang of Yale University amongst other experts shows that High-Frequency Trading is positively correlated with stock price volatility and is:

1. Stronger during periods of high market uncertainty;

2. Stronger among stocks with high institutional holdings; and

3. Stronger among the top 3,000 stocks in market capitalization.

Further, High-Frequency Trading is negatively related to the market’s ability to incorporate information about firm fundamentals into asset prices. Stock prices tend to overreact to fundamental news when High-Frequency Trading is at a high volume. Overall, this financial research demonstrates that High-Frequency Trading may potentially have some harmful effects for the global financial markets. 

Could this explain that when there is a high level of political uncertainty, such as the present Eurozone crisis, the usual explanations given in the media for why the stock market went up or down on a given day appear increasingly irrational or comical and nonsensical?  Is High-Frequency Trading increasingly hi-jacking capital markets?  Is HFT also causing the level playing field to skew in favour of a few larger players with access to powerful automated trading engines to the detriment of much smaller players with simple desktop computers at their disposal?  If so, does HFT make financial markets more manipulated or more efficient?  In the wake of the LIBOR manipulation involving more than 16 top banks around the world, is it plausible to conceive that further probes into High Frequency Trading by regulators in the wake of recent fiascos could yet discover similar anomalies in this space?

Hoovering Up the Pennies via the Milli-Second Competitive Advantage

High-frequency traders benefit from competition among the various stock exchanges, which pay small fees that are often collected by the biggest and most active traders -- typically a quarter of a cent per share to whoever arrives first. Those small payments, spread over millions of shares, help high-speed traders profit simply by ramping up 'churn' volume, even if they buy or sell each share at a modest loss.  High-frequency traders often confound other investors by issuing and then cancelling millions of orders almost simultaneously. Loopholes in market rules give high-speed trading players an early glance at how others are trading. And their computers can essentially commandeer markets to the detriment of befuddled ordinary investors -- who end up surrendering their profits as a result of the confusion caused by smoke and mirrors -- and then the market makers can disappear before anyone else ever knows what really happened!

Defence of High-Frequency Trading

The answers that come back from high-frequency proponents, almost too quickly, are “No, we are adding liquidity to the market” or “HFT is perfectly safe and it speeds up price discovery.” In other words, the traders say, the practice makes it easier for stocks to be bought and sold quickly across exchanges, and it more efficiently sets the value of shares.  However, when one analyses "Flash Crash" events the High frequency traders simply shut off their machines thereby removing vast chunks of 'perceived liquidity' which causes share prices to collapse as a wall of potential buyers totally vanishes.  In their book "Broken Markets: How High-Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio," Joseph Saluzzi and Sal Arnuk, argue that the markets have become fragmented and conflicted venues where powerhouse firms use questionable tactics to take advantage of those who don’t have the sophistication or tools to keep up.

Role of Financial Markets

Over the course of financial history, spanning centuries, the global stock markets have served as a conduit and repository for investors and savers.  They are the platform upon which new capital is raised for start-ups, for emerging companies and for existing businesses.  They are also the primary vehicles for pension funds to provide inflation-protected annuity income to retired individuals.  Has this traditional function of the stock markets been significantly undermined by High-Frequency Trading and the systemic internal conflicts that it generates?

Towards a Rigged-Casino Financial Environment

Investors have been replaced by machines that trade securities not based on intrinsic value decisions but on small trading edges and price-momentum-based algorithms.  High-Frequency Traders have taken over the wheel in an uncertain period in which there is already too much fear and doubt about future economic prospects and exposure of wealth to the global financial markets. These HFT strategies and vehicles have no redeeming social and/or economic value that is immediately obvious. Indeed, one can argue that their influence on the market's volatility is contributing to short feedback loops that then lead to mini-heart-attacks threatening the growth trajectories of many sovereign economies.

Conclusion

1.  The problem with the rising popularity of High-Frequency Trading is that it may be distorting global financial markets significantly, increasingly destabilising those markets and causing the rise of systemic risk. 

2. The consequences of HFT destabilisation are significantly lower growth in those economies exposed to HFT induced volatility, which hinders, delays and deters the decision making process amongst business leaders and private investors.

3.  The unchecked growth of High-Frequency Trading is adding to the distrust that small to medium-size investors already feel toward the financial markets, and they have been pulling money out of equities and equity-linked funds in droves. 

4.  If High-Frequency Traders are allowed to impact the global financial markets continuously, investor confidence -- which has been badly damaged since 2007 -- will not be restored for years to come regardless of any amount of new money created by central banks.

Key Questions to Consider

1. What are the real issues? Do the sharp movements created by High-Frequency Trading improve price discovery or create more noise and cover up the underlying price signal? 

2. Given the short feedback loops in financial markets as a result of HFT, is the underlying real price signal hidden and the price which is visible increasingly the manipulated one?

3. Could short feedback loops totally drown out the real price signal rather than make it more amplified and clearer?

4.  If HFT is a source of instability, are the large players de facto manipulating the markets by switching on- and off- the amplification of volatility?

5.  If HFT creates more instability than it does stability, isn't it essential to monitor and regulate it now before it precipitates another systemic crisis?

What are your thoughts, observations and views? We are hosting an Expert roundtable on this issue at ATCA 24/7 on Yammer.

By DK Matai

www.mi2g.net

Asymmetric Threats Contingency Alliance (ATCA) & The Philanthropia

We welcome your participation in this Socratic dialogue. Please access by clicking here.

ATCA: The Asymmetric Threats Contingency Alliance is a philanthropic expert initiative founded in 2001 to resolve complex global challenges through collective Socratic dialogue and joint executive action to build a wisdom based global economy. Adhering to the doctrine of non-violence, ATCA addresses asymmetric threats and social opportunities arising from climate chaos and the environment; radical poverty and microfinance; geo-politics and energy; organised crime & extremism; advanced technologies -- bio, info, nano, robo & AI; demographic skews and resource shortages; pandemics; financial systems and systemic risk; as well as transhumanism and ethics. Present membership of ATCA is by invitation only and has over 5,000 distinguished members from over 120 countries: including 1,000 Parliamentarians; 1,500 Chairmen and CEOs of corporations; 1,000 Heads of NGOs; 750 Directors at Academic Centres of Excellence; 500 Inventors and Original thinkers; as well as 250 Editors-in-Chief of major media.

The Philanthropia, founded in 2005, brings together over 1,000 leading individual and private philanthropists, family offices, foundations, private banks, non-governmental organisations and specialist advisors to address complex global challenges such as countering climate chaos, reducing radical poverty and developing global leadership for the younger generation through the appliance of science and technology, leveraging acumen and finance, as well as encouraging collaboration with a strong commitment to ethics. Philanthropia emphasises multi-faith spiritual values: introspection, healthy living and ecology. Philanthropia Targets: Countering climate chaos and carbon neutrality; Eliminating radical poverty -- through micro-credit schemes, empowerment of women and more responsible capitalism; Leadership for the Younger Generation; and Corporate and social responsibility.

© 2012 Copyright DK Matai - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


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