Click here to read this article in pdf format: August 12 2012
In our last letter, we made some comments on high-frequency trading. Today, we want to briefly analyse, from a macroeconomic perspective, the underlying ideas thrown in its favour, as well as the impact this activity has on the capital markets. Why is this important? Because more than half of the trading volume in equities in the main world exchanges is driven high-frequency trades today (More than 70% of volume in the US exchanges alone).
What is high-frequency trading? We will never exhaustively address this issue here. We recommend that you do your own research on the subject. There are numerous articles on this topic. High-frequency trading (HFT) consists in using sophisticated technology to trade securities. It is highly quantitative, employing algorithms to analyze incoming market data. HF investment positions are held only very briefly, with HF traders trading in and out of positions intraday tens of thousands of times. The important feature is that at the end of a trading day there is no net investment position. Processing speed and access to the exchanges are critical.
HFT strategies can be broadly thought in terms of three main groups: Those that provide liquidity, those that trade headlines and those that trade statistics. The statistical ones are the easiest to understand (at least for us): They are based on technical analysis, correlations. The headline strategies seek to profit from momentum trading, filtering information that describes intra-day action in the exchanges. The so-called liquidity strategies are either based on market making (to profit from bid/ask spreads) or from rebate trading. Operationally, HF traders collectively send millions of orders, the most part of which (we understand above 90%) are cancelled before they are even hit. This often causes delays in the exchanges that receive them, potentially creating arbitrage opportunities in those stocks that trade in multiple exchanges.
Two main factors have been put forward in support of HFT. We will quickly dismiss them:
a) HFT provides liquidity to markets
We think this point has been misunderstood, because at a macro level, one must not refer to the liquidity of a particular asset, but of liquidity in general or, more properly, liquidity preference, since liquidity is not a condition intrinsic to any asset, but the result of preference by market participants.
Indeed, HFT may and does provide liquidity to a particular asset, but it is a different thing to say that HFT provides liquidity to the market, at an aggregate level. At an aggregate level, the liquidity preference of market participants is what matters. If they want to be liquid, they have the means to do so either by holding money or by changing it for commercial paper or short-term obligations of borrowers with a solid and steady cash-flow stream. Collectively, for market participants to allocate some of its savings to liquid assets, there is no need to see millions of quotes a day, for instance, on a risky junior mining company with assets overseas, thereby creating the illusion that the junior mining equity space is liquid.
Market participants do not need to see the universe of liquid assets expanded to satisfy their respective liquidity preferences. And if they have to get their savings out of an asset which until a minute ago seemed liquid but now is not, they will be able to do that with or without HFT, because there is no reason to believe that under a shock, the HFT bid will not disappear in a nanosecond, making the situation even worse.
Having said this, it is clear that the impact of the quoting activity by HF traders generates a distortion in the capital markets and particularly, in the capital structure of an economic system. Companies that, given the nature of their businesses, would have been forced to raise secured long-term bank debt to fund their capital expenses before the influence of HFT, may now find it easier and cheaper to raise equity. And those with investable assets captive in the system (i.e. registered funds, 401ks) will now fall prey to very risky projects, under the belief that they are protected by electronic stop-loss orders. Banks that might have been willing to provide secured lending to these equity issuers, will now find that they can only bid for less profitable working capital lines, under the belief the loans are protected by stock pledges! And it gets even worse: Those who invest in this equity may decide to pledge it under, say a 3x coverage ratio, to borrow funds and invest in even riskier, “more profitable” assets!
The liquidity argument in favour of HFT is just one more Keynesian version of the notion that inventing purchasing power ex-nihilo can get us somewhere better, but this time, applied to the capital markets in particular.
How does HFT invent purchasing power? The liquidity premium embedded in assets that wouldn’t otherwise be liquid or would not even exist, is the purchasing power we refer to. For this same reason, those who defend HFT now fear that by prohibiting it (just like their fear to prohibit fractional reserve lending) we will see a collapse in valuations. Unfortunately, that collapse will eventually take place, only still bigger and affecting global capital markets.
b) HFT facilitates the process of price discovery
What media and those in favour of HFT commonly refer to price discovery is nothing else but algorithms sniffing stop losses, causing volatility in the process. There really isn’t anything particular about HFT with respect to pricing, which human beings cannot achieve on their own. Throwing orders to exchanges that are immediately cancelled to test floors or caps on the price of a certain asset cannot be credited with price discovering. Indeed, efficient markets are those which always challenge valuations and in the process, prevent the misallocation of resources from further growing. But the challenge of valuations always represents the challenge of their underlying assumptions: Sales, leverage, productivity, management, etc. Shaking the nest, the way HFT does (with the sudden introduction of millions of quotes) to “discover” key levels is hardly the feature of a healthy capital market.
Let us bring an analogy: Human lives are not traded. Yet, if a criminal kidnapped somebody’s daughter and asked for a ransom, he would certainly be “discovering” the price of her life: The parents of the girl, having offered all they had in immediate liquid assets, would have told the criminal what the price for their daughter is. Now, this is exactly what algorithms do when testing price levels in the absence of economic news, as we have painfully seen across a myriad of asset classes.
This is not a healthy way to price assets, because just like the parents had never thought of trading her daughter for money, market participants not challenged by economic developments but by millions of fake orders, were forced to do so. A trade actually took place in an otherwise illiquid market but…what will happen next time? Neither the daughter will be left alone by the parents nor our market participants will be there for the criminals to profit from them, which is why retail money will keep flowing out of the stock exchanges (the system) as long as the status-quo is not changed.
Perhaps too, our fictional criminal will regret not having given the father more time to liquidate more assets, but of course, that would have come at the cost of higher risk. There is no difference between the criminal’s short-term line of reasoning and that which keeps HF traders from keeping positions for longer than seconds or minutes. Therefore, if we were really thinking about price discovery, neither our criminal nor HF traders did discover the true price. In the end, all we ended up with was volatility that will exponentially increase, as the exchanges impacted by HFT see participants leave to over-the-counter markets (like real estate?)…Is this the actual reason behind the high percentage of HFT volume in exchanges? Is it because we are leaving the exchanges all to HF traders?
The market crashes driven by HFT, like that on the NYSE in May 2010 or the recent one affecting the Knight Capital Group should be a big wake-up call. This is a new technological change which the Austrian School of Economics should further analyse. We, at “A View from the Trenches”, just wanted to leave our two-cent contribution with our thoughts. We leave with an interview on the subject, to Scott Patterson, author of “Dark Pools”, dated August 8th:
Martin Sibileau
