« »

Tuesday, July 15, 2014

How high-frequency trading is leaving investors, the market and regulators in the dust

high frequency trading
The new market movers have increasingly become a less human economic reality, and more of a cyber-market event for much of recent past. This is because the digital share-trading process has evolving to a level of ultra-fast securities market making that pitches algorithms against one another in a coded timing competition beyond direct human decision making. 

According to Bloomberg, high frequency trading accounts for about 50% of total stock market volume. Furthermore, both the Chicago Federal Reserve and the New York Attorney General have both demonstrated concerns about the practice becoming out of hand. Recent "Dark Pool" investing scandals have also comprised the financial integrity of investment services.

Numerous examples exist detailing the systemic and commercial problems associated with high frequency trading. One unsettling instance of errant HFTs was when a capital investment firm named Knight Capital that lost $445 million in less than an hour per Fortune. The reason Knight Capital lost so much money in one day was because its computer trading programs got outplayed in a way similar to two computers playing chess. Moreover, according to CNBC, Knight Capital stated a market making glitch in its high-frequency trading programs led to erratic high-volume trades. That led to 150 stocks experiencing volatility inconsistent with the broader market trend for that day. This is not the first time an event like this has happened either.

Another unfortunate digital trading even occurred back on May 6, 2010, an occurrence widely known as the “Flash Crash”. It caused market mayhem, but to a larger extent than the Knight Capital event. Moreover, unlike the events caused by Knight Capital, this event began with a commodity market trade by a financial firm. Within just 20 minutes, computer programs contributed to a selling panic that caused market losses to the tune of $862 billion per Bloomberg. The same event is described by the Wall Street Journal as being triggered by “unusual price movements,” “data disruption,” and “unusual trading activity.”

High-frequency trading is making the efficient market hypothesis seem quaint or inapplicable to stock markets in a traditional sense. Moreover, since digital trading algorithms are currently competing in a different kind of efficient market amongst themselves, the meaning of efficiency changes from  valuation made by humans to the most advantageous trading by software. Additionally, according to the New York Times, high-frequency traders are able to unlawfully influence share prices to their benefit making regulation of the practice all the more important. Left unregulated, there is little to stop such trading from causing market mayhem either deliberately through erratic trades, or unintentionally via errant trades.

In February 2012, the Commodities Futures Trading Commission decided to form a sub-committee on high-frequency trading and more recently, the U.S. Securities and Exchange Commission has also expressed greater concern over the hazards of HFT per Quote Media. Whether or not regulatory moves such as this will have any effect will at least partly depend on how well they read and interpret computer code, but also on how regulations enforce fair market competition and  protect consumers.

What past events and current digital trading trends imply is that market price movements are increasingly being defined by high-frequency trading programs. When high-frequency trading algorithms out-compute one another, they are capable of doing so at the expense of investors as is the case with "dark pool investing" mechanisms, and this compromises the fiduciary responsibility of investment services.

Image: US-PDGov