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The Achilles Heel of Markets?

London, UK - 30th May 2010, 18:20 GMT

Dear ATCA Open & Philanthropia Friends

[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]

It has been the worst May for stocks since 1940. The last time May was this bad, neither had Pearl Harbor been bombed forcing the US to enter World War II, nor had the US recovered from the Great Depression. Although suppressed for much of the global markets recovery that began in March 2009, volatility has sprung back with a vengeance in May. On May 21st the "fear index" -- the "volatility index" of the Chicago Board of Options Exchange, also known as VIX -- rose to a 12 month high. May 6th, the day of the "flash crash," saw the biggest intraday point drop ever in the Dow Jones Industrial Average. The last-hour market swings, as the European debt crisis injects more uncertainty, are also increasing with every passing day. This volatility reflects a lack of buying interest among long term investors and an intra-day focus for high-frequency traders in the absence of a clear market direction.


High Frequency Trading

Super Arbitrage

The role of high-frequency trading is gathering pace, commanding a bigger and bigger share of financial markets' activity worldwide in equities, bonds, commodities, futures and currencies. High-frequency traders are behaving like computer jockeys. They run complex trading algorithmic software on superfast computers and search the markets for tiny price differentials so that they can carry out super arbitrage. By trading hundreds of millions or even a billion units a day at lightning speed, high-frequency traders pick up fractional pennies each time. The more volatile the market, the easier it is for them to make money jumping in and out of assets across multiple exchanges. High-frequency traders are really just trying to skim the bid to offer spread on a trade. It may only be as low as $0.01 on many trades but, if one does it for 100,000,000 -- 100 million -- units that's over one million dollars a day of profit! High-frequency trading firms rarely go home with a position if they can help it because they make money by maximising transactional volume and minimising risk.

What Does Volatility Mean?

Markets become volatile when liquidity dries up. This means people can't trade stocks at a fair price, when they want. High-frequency traders thrive off volatility, because when liquidity is in short supply, it becomes very profitable for them to provide it. On days with big movements, in the realm of triple digits, high-frequency traders can make a lot of money via this super arbitrage. As a result, May has proved to be the biggest gold mine for high-frequency trading firms since the crash of late 2008 and early 2009. While many long-term investors lost their shirts during The Great Unwind (2007-?) and The Great Reset (2008-?), the high-frequency traders posted huge profits, as they are doing now.

Shadow Markets

In their defence, high-frequency traders say that because their intense trading provides liquidity, they help markets run smoothly, improving the environment for all investors. They say their actions make the markets more functional and fair to typical investors. Given that the high-frequency traders and broker dealers have a symbiotic relationship, they are both actively masquerading as liquidity providers when in fact they are normally liquidity takers, the knowledge transfer of the transactional information being all important. It is clear that high-frequency trading serves no larger purpose. It does not raise capital for companies, create jobs or stimulate innovations in the broader economy. The trades remain completely divorced from underlying economic fundamentals. The high-frequency traders know little or nothing about the companies their computers are feverishly buying and selling. If one combines the speed at which they operate, the outsourcing of decision making to computer algorithms, and an almost complete lack of regulation, this shadow market can fuel and exaggerate volatility.

Anti-Value Investing

High-frequency traders have been branded as the new "black hats" of high finance. Their computer-driven methods, which now account for upwards of two thirds of all US equity volume, are proliferating. To a large degree, fundamental investment strategies -- such as buying and selling stocks based on a company's long term performance -- have taken a back seat to high-frequency trading algorithms hunting for inefficiencies in daily pricing and super arbitrage opportunities.

Reach, Richness and Speed

High-frequency trading has been spreading from the US and Canadian stock markets into new geographies -- Europe, Asia and Latin America -- and all asset classes including equities, bonds, commodities, futures and currencies. Assuming the new financial regulatory reform bill forces over-the-counter derivatives on to exchanges, high-frequency traders will no doubt trade them too. Every day, things are getting faster in the world of high finance and trading. Four years ago, executing a trade in a millisecond -- one thousandth of a second -- was considered fast; now the top high-frequency trading firms and broker dealers are trading in microseconds. That's one millionth of a second.

Conclusion

Law-makers and regulators are right to get nervous. Senator Ted Kaufman -- Democrat from Delaware -- who understands the risk of high-frequency trading, or HFT, says, "I'm afraid that we're sowing the seeds of the next financial crash." He has called for the Securities and Exchange Commission (SEC) to investigate high-frequency traders and the impact they have had on the broad markets.

In the aftermath of the May 6th "flash crash", the Securities and Exchange Commission (SEC) has recently voted to propose rules that would give the agency and securities exchanges more timely information about high-frequency trades so that they can better oversee the markets. The proposal requires exchanges and broker dealers that trade on the exchanges to provide detailed information about quotes, orders and trades to what would be a newly created central repository.

Whilst the creation of a central repository may be helpful, it is unclear how this could prevent a "flash crash" caused by high-frequency trades in the future. Human real time is measured and understood in minutes and seconds, whereas the machines are trading in millionths of seconds. In order to be able to understand what happens in a future "flash crash" the regulators would have to play the data from a central repository in slow motion over days or even weeks! What good is it to drive an open-top car at high speed with one's eyes glued to the rear view mirror?

[ENDS]

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Best wishes


ATCA: The Asymmetric Threats Contingency Alliance is a philanthropic expert initiative founded in 2001 to resolve complex global challenges through collective Socratic dialogue and joint executive action to build a wisdom based global economy. Adhering to the doctrine of non-violence, ATCA addresses asymmetric threats and social opportunities arising from climate chaos and the environment; radical poverty and microfinance; geo-politics and energy; organised crime & extremism; advanced technologies -- bio, info, nano, robo & AI; demographic skews and resource shortages; pandemics; financial systems and systemic risk; as well as transhumanism and ethics. Present membership of ATCA is by invitation only and has over 5,000 distinguished members from over 120 countries: including 1,000 Parliamentarians; 1,500 Chairmen and CEOs of corporations; 1,000 Heads of NGOs; 750 Directors at Academic Centres of Excellence; 500 Inventors and Original thinkers; as well as 250 Editors-in-Chief of major media.

The Philanthropia, founded in 2005, brings together over 1,000 leading individual and private philanthropists, family offices, foundations, private banks, non-governmental organisations and specialist advisors to address complex global challenges such as countering climate chaos, reducing radical poverty and developing global leadership for the younger generation through the appliance of science and technology, leveraging acumen and finance, as well as encouraging collaboration with a strong commitment to ethics. Philanthropia emphasises multi-faith spiritual values: introspection, healthy living and ecology. Philanthropia Targets: Countering climate chaos and carbon neutrality; Eliminating radical poverty -- through micro-credit schemes, empowerment of women and more responsible capitalism; Leadership for the Younger Generation; and Corporate and social responsibility.



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