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.
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