In yesterdays note, we referenced a paper written for the United Nations Conference on Trade and Development titled The Synchronized and Long-Lasting Structural Change on Commodity Markets: Evidence from High Frequency Data We wanted to go into a bit more detail today on the paper. The paper states that the E-Mini S&P 500 futures contract is the most traded index futures contract in the world. There were 121 million trades in it in 2011. This is a 450% increase since 2007 when there were only 22 million trades. The authors cite that use of electronic trading as the reason for this increase. Most likely, Reg NMS which went into effect in 2007 and ballooned equity volumes, was the real reason this contract rose so much in volume.
The paper focuses on correlations and notes how prior to 2008 correlations between equities and commodities were near zero. This lack of correlation gave comfort to investors who wanted to diversify their portfolio with different asset classes. But something happened after 2008. The correlation between equities and commodities started to become greater. The authors find the correlation between crude oil jumped from 0.00 prior to 2008 to 0.50 after 2008. They found similar results from other commodities.
“The very existence of cross market correlations at such high frequencies is consistent with the idea that recent financial innovations on commodity futures exchanges, in particular the high frequency trading activities and algorithm strategies, have an impact on these correlations. “
The authors conclude that the reason why the correlations have increased so much is because of the rapid expansion of trend following strategies. They believe that these trend following strategies can “affect the price discovery mechanism.” Here is what they say about trend following strategies;
“Trend following strategies, for instance, typically try to benefit from upward and downward trends by herding. Contrary to common wisdom, where first mover may enjoy a monopoly rent, trend-following strategies potential returns actually increase with the increasing number of imitators and increasing momentum, because the greater the number of trend-followers, the stronger the trend. The competition among trend-followers lies in identifying first changes in trends: first to invest at the trend inception, first to reverse position when the trend fades.”
They believe that HFT is mainly responsible for this sharp rise in equity/commodity correlations. They state: “We think that HFT strategies, in particular the trend-following ones, are playing a key role…the very existence of cross-market correlations at high frequencies favours the presence of automated trading strategies operated by robots on multiple assets. Our analysis suggests that commodity markets are more and more prone to events in global financial markets and likely to deviate from their fundamentals.”
In other words, HFT has totally distorted the pricing of commodities. The old laws of supply and demand have been suspended. The prices that you pay for commodities now have more to due with an HFT scalping a few pennies than they actually have to do with real economic factors. So, next time some HFT proponent claims that they are just providing liquidity and shrinking spreads, ask them if they know they are actually distorting prices.