Global Crisis/Innovation Blog

High Frequency Trading: One More Reason to Worry

By Shlomo Maital

Global markets and those who wheel and deal in them seem able to provide ordinary people with newer and better reasons to worry,   far faster than regulators can bandage wounds and patch up the leaks.   High Frequency Trading (HFT) is an example. HFT is an innovation, in which computer experts use super high-powered computers to identify small profit opportunities, and capture them within milli-seconds, far faster than human eyes, brains and fingers can move.  These experts care nothing about fundamentals or companies, simply seek small arbitrage profits.   HFT crashed the markets on Thursday May 6, now known as Hysterical Thursday.  The US stock market fell 6 per cent…in 20 minutes! And it will likely happen again.

Here is what happened according to  Nina Mehta, Lynn Thomasson and Paul M. Barrett

Bloomberg Business Week, Features, May 20  (“The machines that ate the market”):

“Once upon a time, human beings oversaw the trading of stocks. They’ve been replaced by a complex system of computers that can produce a scary new kind of mechanized panic. Hysterical Thursday did no apparent long-term harm. Some venerable stocks dropped to a penny apiece before bouncing back. Overall, the Standard & Poor’s 500-stock index declined 6.2 percent, from 1,136.16 to 1,065.79, in a 20-minute span—an $862 billion paper loss—before recovering to finish down 3.2 percent.  The brief crash threw up a flare that illuminated a financial topography that was unfamiliar even to many experienced investors.

A Bloomberg Businessweek investigation into those harrowing minutes revealed the extent to which the market is now dominated by quick-draw traders who have no intrinsic interest in the fate of companies or industries. Instead, these former mathematicians and computer scientists see securities as a cascade of abstract data. They direct their mainframes to sift the information flows for minute discrepancies, such as when futures contracts fall out of sync with related underlying stocks. High-frequency traders (HFTs), as they’re known, set an astonishing pace. On May 6, 19 billion shares were bought and sold; as recently as 1998, 3 billion shares constituted a very busy day.

This is not the first time computers have wreaked stock market havoc.  On Oct. 19 1987 the NYSE fell 20 percent in one day, because of ‘programmed trading’ — computers programs that traded spot (stocks for immediate delivery) and derivatives (options and futures).  Problem was, the spot trading was on the NYSE and the derivatives, on the Chicago exchange.  A doom loop was created in which falling spot prices triggered selling, and that in turn triggered derivatives selling, which triggered spot selling, etc… Eventually authorities put a stop to it with “circuit breakers”.    On May 6:   “The SEC and the Commodity Futures Trading Commission stated,  ‘We continue to believe that the market disruption of May 6 was exacerbated by disparate trading rules and conventions across the exchanges.’   It’s that old déjà vu all over again.

I often ask financial traders and speculators what is the redeeming social value of what they do.  I always get the same vapid answer: Liquidity.  Apparently,  HFT creates “liquidity”.   Let me translate.

Liquidity means generating huge volumes of traffic, meaning that small profits on each transaction, multiplied by billions of transactions, yields huge profit.  The activity draws in unsuspecting amateurs into the game, bringing new money,  much like suckers pulled into a poker game manned by hardened professionals who take their money with glee.

Eventually the regulators will get control of HFT.  Until they do,  if you’re in the market, expect more Hysterical Thursdays..and Mondays, Tuesdays……  or simply, stay out of the market.