High-frequency traders push markets towards the precipice
Regulators need to get a grip on new trading technologies or risk increased volatility that will hurt investors
Bigger, ever faster, computers with algorithm trading programmes have spawned a new breed of market participant, the high-frequency traders, who it is estimated account for more than 70 per cent of the volume of shares traded on US exchanges daily. Photograph: Joe Corrigan/Getty
The rules of engagement in markets have changed and perhaps not for the better. Before the computer age, market participants could look each other in the eye. Understanding who was buying and who was selling and why was straightforward.
The raison d’etre of markets is to match the corporate world’s need for capital with investors’ savings. Traders, trying to squeeze out a return from market trends, add to the liquidity in the secondary market.
The computer age added a new and, at first, welcome dimension. More data can be processed. Faster reporting can be delivered. Costs have been reduced.
But bigger, ever faster, computers – supercomputers – with algorithm trading programmes have spawned a new breed of market participant, the high-frequency trader.
High-frequency traders operate as brokers or market makers and, as such, have similar direct access to the stock exchanges’ order flows. They operate in the physical as well as derivatives and futures markets.
In many cases, their powerful computers are located near to and even within stock exchange buildings, providing them with a slight time advantage, measurable in milliseconds.
But to a powerful computer, the ability to react in milliseconds is all the advantage the high-frequency trading firm needs to gain an advantage over all other market participants, be they traders or investors.
What is becoming ever clearer, though, is many of their activities exacerbate volatility in markets. Fear, greed and hope have always played their part in market activity, making the markets more volatile than the underlying fundamentals warrant. You can’t change human nature and volatility is part and parcel of the markets.
Set out to cause volatility
But to deliberately set out to cause volatility with the aim of profiting from it seems against the basic principles of the market.
One particular activity of the high frequency traders is the use of computerised trading programmes that send out thousands of orders in milliseconds only to withdraw the same orders a millisecond later. The aim is to sniff out big institutional orders – buy or sell – and to then front-run these orders, scalping profits as they go.
High-frequency traders counter with the age-old argument that they add liquidity to the markets and that more liquidity is good. But the evidence is mounting that, at times of stress, their activities lead to the exact opposite – a collapse of liquidity.
At times of market stress, other market operators, seeing a deluge of computer-driven sell orders, perhaps from several high-frequency traders using the same computer-driven algorithm programmes, also move to sell and exit before prices decline even further. Selling begets selling.
Investigations by the Securities and Exchange Commission, the US markets’ regulatory body, after the “flash crash” on May 6th, 2010, which saw the S&P 500 drop an unprecedented 9 per cent in 10 minutes, highlighted the significant part played by high frequency trade operators that day. Their impact on the 17 per cent decline in the S&P 500 between July 5th and August 8th, 2011, is also the subject of regulatory scrutiny.