A few weeks ago, I wrote a piece about glitches in computer
trading (see Lord Copper 3rd September 2013 “Fat Fingers and
Responsibility”). Since then, I've looked a bit more at high-frequency and
algorithmic trading and I came across this article (Goldman’s Geek Tragedy) in ‘Vanity Fair’ by Michael
Lewis, of ‘Liar’s Poker’ fame. It’s the story of a man who worked on writing
algorithms for high-frequency traders at Goldman Sachs. I’m not going to go
into detail here about why he ended up in court and then gaol, but the article
is well worth a read. It set me thinking, though, about the issue of
high-frequency trading and where it sits in our perception of how markets work.
Investors, Speculators and Profits
Traditionally, equity markets exist to enable entrepreneurs
to raise capital to fund their enterprises; commodity markets began with the
function of allowing producers and consumers to hedge their requirements. Now,
in order to make things run smoothly, another set of participants was needed;
step forward the investor or speculator community. In equity markets their role
as investors was to provide the capital necessary and in commodities as
speculators they helped even out the timing mismatches inherent in a futures
market. In both cases, clearly, they worked with the expectation of turning a
profit on their investment or speculation. The important bit, though, is that
they have a vital part to play in the operation of the system; without them,
markets would not be able to function properly. In other words, broadly, they
provide liquidity to markets and in return for that they are ‘allowed’ by the
market to make a profit – that doesn't mean they always do, of course: wrong
decisions are always possible. That’s been the pattern of markets broadly since
they started to dominate the capitalist world.
Where Does High-Frequency Trading Fit?
But does high-frequency trading fit into that mould?
Certainly the intention of its proponents is to make a profit – otherwise why
would they bother? – and from the way it is increasing, we should infer that
they are successful at that. It’s difficult to pin down the profitability of
the HFTs, but we are able to find statistics which suggest that up to 70% of
trading on US stock exchanges is of this type. That seems to make the case that
high-frequency trading is taking money out of the market; the question is
whether or not it is putting anything in of a similar value. The line taken by
the high-frequency traders is that they provide liquidity to the market, they
narrow the bid-offer spread and they reduce volatility. All those taken
together, they say, lower the cost of doing business for other, more
traditional, market participants and that’s what they offer to the market in
return for the money they take out as their profits.
Examine the Claims
But do those claims really
stand up? Given the statistic above of the amount of business that stems from
HFT, it’s a fair comment that market volume is increased. However, I’m not sure
that that truly represents an increase in liquidity. That may sound strange,
but volume which is not really available – since it is in and out in
milliseconds – is arguably not liquidity available to the market as a whole. Narrowing
bid-offer spreads? Well, I would argue that the undoubted move in that
direction we have seen has at least as much to do with open access and direct
input. The fact that traders everywhere can have a real-time sight of the
market and the ability to enter orders directly is what has narrowed spreads;
HFT is only one part of that, and there is no convenient way of assessing its
sole influence. Reducing volatility is perhaps the most contentious claim of
all. Inserting a series of millisecond trades into a market would be a strange
way of smoothing that market. Volatility is reduced by consistent flows of
orders, not by opportunistic attempts to squeeze ‘extra’ trades into a market.
And that really is the nub of it. High-frequency trading, by its very nature,
is working at the level of trying to get a pre-emptive additional trade in
between buyer and seller, using the tools of very low latency.
A Tax on Investors?
The cost of trading has undoubtedly decreased in recent
years, mostly because of the benign effects of electronic trading –
order-routing, direct order input, reduced commissions and so on. That
reduction in cost is not thanks to HFT; in fact, it may have been greater still
without HFT. It looks as though what I am saying is that it’s fine to speculate
in markets as long as you don’t do it at the warp speed of the high-frequency
traders; that’s not quite the point, though. Speculation is part of the way
markets operate and indeed a very necessary part. So consider this -
high-frequency traders take money out of the market by squeezing in between
trades. The trades they do have no other economic value and since we all know
there is no such thing as a free lunch, one could argue that their activities
act as a tax on other investors, taking money out of the market without adding
any form of value to it. That effect is disguised – for now – by the overall
reduction in dealing costs.