This is not your father’s stock market. Over the last 10 years, the structure of the U.S. equity market has changed drastically. Gone are the days when the NYSE and its specialists dominated stock market trading. Today, as many as 50 different venues in the U.S. trade equities. Now, almost all stock trades are done electronically. The NYSE specialists who were once obligated to make an orderly market by providing bid and offer quotes during periods of market stress have been effectively replaced by high-frequency trading firms (HFTs).
HFTs are opportunistic traders that operate with little capital, hold small inventory positions, and are under no obligation to make an orderly market during periods of stress. These firms use ultra-high-speed and sophisticated programs to predict stock prices milliseconds into the future. The most successful HFTs are not the firms with the best insights on a company, but those with the fastest programs located closest to the exchange’s servers (co-location). HFTs don’t use fundamental analysis to make trading decisions. Instead these firms use information in order books, past stock returns, cross-stock correlations, and cross-asset correlation to make decisions.
While some might believe that HFTs are benign market participants, just the opposite is true. High-frequency trading now accounts for 70% of U.S. stock market volume—an astonishing statistic to be sure. The purpose of financial markets is to efficiently allocate capital to its highest and best use, yet a majority of the daily trading in stocks is conducted by investors with no interest in the value of the companies they buy and sell. HFTs are interested only in the price of a stock over the next second or two.
HFT proponents will tell you that high-frequency trading poses no risk to the broader market, and in fact increases liquidity and keeps transaction costs low. But the counter-argument is that HFT liquidity is transitory and shallow (large orders are hard to fill) and while HFTs have helped drive down bid-ask spreads on stocks, they are extracting those profits from investors in other ways (some of the strategies are discussed later).
Because HFTs are not under the same obligation as NYSE specialists to provide liquidity, they often pull back from the market during periods of stress, creating a liquidity vacuum, which can result in cascading prices. The so-called “Flash Crash” in 2010 was partly caused by several major HFT firms stepping away from the market in order to limit risk. Here is what a joint CFTC-SEC report on the “Flash Crash” said about the structure of today’s stock market.
The Committee believes that the September 30, 2010 Report of the CFTC and SEC Staffs to our Committee provides an excellent picture into the new dynamics of the electronic markets that now characterize trading in equity and related exchange traded derivatives. While these changes have increased competition and reduced transaction costs, they have also created market structure fragility in highly volatile periods. In the present environment, where high frequency and algorithmic trading predominate and where exchange competition has essentially eliminated rule-based market maker obligations, liquidity problems are an inherent difficultly that must be addressed. Indeed, even in the absence of extraordinary market events, limit order books can quickly empty and prices can crash simply due to the speed and numbers of orders flowing into the market and due to the ability to instantly cancel orders. Liquidity in a high-speed world is not a given: market design and market structure must ensure that liquidity provision arises continuously in a highly fragmented, highly interconnected trading environment.
More troubling than the transitory liquidity that HFT firms provide are some of the dubious strategies employed by these firms. Below are some examples of the strategies used by high-frequency trading firms—most are illegal but difficult for regulators to detect.
Front running – Using computer algorithms to detect and trade ahead of institutional orders.
Quote Stuffing – Submitting and then immediately cancelling trades in order to gain a few-milliseconds speed advantage over the competition. The computers of the HFT who submits the erroneous orders don’t have to process that information, whereas the competitors’ computers do.
Layering – Using hidden orders on one side of a trade and visible orders on another side of the trade to manipulate prices. For example, if a trader wants to buy a stock at $5.01, but the current bid is $5.02 and the asking price is $5.03, the HFT may put in an order that is hidden to buy at $5.01. It will then flood the market with orders to sell at a price higher than the current asking price, let’s say $5.05. Others will see the selling pressure and adjust their bid and ask prices lower, likely hitting the HFTs intended bid price of $5.01.
Spoofing – A trader may initiate the rapid-fire submission and cancellation of many orders, along with the execution of some trades to “spoof” the algorithms of other traders into buying or selling more aggressively, which can exacerbate market moves.
My goal is not to suggest that all high-frequency traders are unscrupulous and the practice should be banned (though I suspect few would actually miss it). But it would seem to me that high-frequency trading has become so vital to the proper functioning of today’s stock market that, at the very least, more oversight and disclosure should be required of these firms. There is enough uncertainty and volatility in today’s markets. The last thing investors need is for the HFT crowd to magnify volatility and distort the stock market. We have chairman Bernanke for that.
Jeremy Jones, CFA
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