James Surowiecki (writer in the New Yorker) wrote a very informative review (in the New York Review of Books) of Michael Lewis’ book ‘Flash Boys’ about the rise of high-frequency trading (HFT) on Wall Street. As the name suggests, high-frequency traders buy and sell in large volumes and at an extraordinary fast pace, trading thousands of times a second. The decisions of the trader are driven by complex algorithms which are designed to follow a defined set of instructions in order to generate profits at a speed and frequency that is impossible for a human trader. The defined sets of rules are based on timing, price, quantity or any mathematical model.
It is estimated that 70% of trading in US stocks is done using. Lewis notes that:
By the summer of 2013, the world’s financial markets were designed to maximize the number of collisions between ordinary investors and high-frequency traders – at the expense of ordinary investors, and for the benefit of high-frequency traders, exchanges, Wall Street banks, and online brokerage firms.
Advocates of HFT will tell you that HFT provides liquidity and this means that the market has a lot of buyers and sellers which suggests that you can make trades without moving the price too much. A liquid market means that people will be more likely to invest. However there are those that worry about the liquidity of HFT as it could be illusory as it could disappear very quickly if stock prices collapse. Andrew Haldane of the Bank of England put it – the fear about this liquidity is that ‘in wartime, it disappears’. Furthermore, HFT has also produced huge swings in stock prices. On 6th May 2010 – know as the ‘Flash Crash of 2.45pm’ – the DJIA fell 9% in 5 minutes but then recovered most of that loss in the subsequent few minutes. But what is most worrying is that nobody can agree what happened because nobody had any control over it. It seems that we are writing things (algorithms) that we can no longer read. We should be worried about HFT as it reduces the amount of the quantity of real and valuable information in the stock market system. It make the system as a whole less stable and more risky. And it devotes an enormous amount of resources to an arms race that is of dubious value.
HFT and the real economy
A recent study of the commodity market found that up to 70% of all price movements in those markets didn’t correlate to events in the global economy. The price movements were driven by algorithms reacting to internal action in the market. This not only makes the market dumber but also a lot more unstable as humans find it impossible to oversee it – e.g Flash Crash of 2.45pm. If HFT traders add liquidity to the market then when the market crashed on 6th May they should have stepped in by buying falling prices of stocks. Turmoil in the markets is nothing new but the speed that it happens today makes trading harder to control raising systemic risk. Some companies will go to get great lengths to improve the speed of trades. In July 2010 a one-inch cable was completed to send a signal from Chicago to New Jersey at a cost of US$300 million. The improvements brought down the estimated roundtrip time of the signal from 13.1 milliseconds to 12.98 milliseconds. But when you are an algorithm 0.3 milliseconds is a long time. The billions of dollars that have been put into HFT over the last 6 years have only had a small impact on the ordinary investor. HFT looks like an arms race as it consumes an enormous amount of resource but generates very little social value and damages the market in the process.