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HFT Debate Arrives On Main Street

19

October, 2011

We have certainly come a long way in the market structure debate. It was almost three years ago that we released a paper called “Toxic Equity Trading” that highlighted some troubling issues in the equity market, most notably the rise in high frequency trading. Soon after that paper was released in December 2008, events started happening quickly in the equity markets. There was the Goldman Sachs programmer who got arrested for stealing computer code, the “flash order” controversy, the SEC Concept Release and of course the Flash Crash. However, even with all these events, the market structure debate remained inside the institutional trading community. Lobbyists and sponsored academic studies tried to keep the lid on any issue and prevent it from reaching the public debate. But the unprecedented recent volatility has finally pushed the debate to the average investor. The evidence of this is a note titled Welcome to the Machine: High-Frequency Trading Domination written by Liz Ann Sonders, Chief Investment Strategist for Charles Schwab and Co. In this note, Ms. Sonders attempts to explain the pros and cons of high frequency trading to her retail client base. We think she did a very good job. Here are some excerpts from the note:

“The proponents for HFT claim that it brings more liquidity to the market while keeping transaction costs low via narrowing bid-ask spreads, and a recent study by the Capital Markets Cooperative Research Centre of Australia supports that view. But there are plenty of studies that refute the aforementioned benign characterization of HFT. One such study was completed last November by Yale Professor X. Frank Zhang, who found that “HFT is positively correlated with stock price volatility” and that it’s “especially strong for the top 3,000 stocks in market capitalization and stocks with high institutional holdings.” Zhang’s most condemning find is that “the positive correlation between HFT and volatility is also stronger during periods of high market uncertainty.”

“In times of high market volatility, stock movements tend to be more correlated and the link has grown increasingly strong since the mid-2000s. That was when regulatory reform encouraged financial exchanges to switch from floor-based trading to electronic trading. Two things have happened since then that are coincident with the emergence of trading-platform fragmentation and HFT. First, as noted, volatility and correlations have both been higher. Second, the slope of the volatility/correlation curve is steeper, meaning that a rise in volatility today has a more pronounced impact on correlations than in the past. HFT seems to have reduced bid-ask spreads (and thus transaction costs) in less-volatile times, making markets work more smoothly. But it appears to have done the opposite in more-volatile times, adding to market stress and amplifying volatility.”

“This increase in correlations is throwing for a loop the notion of diversification in investors’ portfolios as a way to minimize risk in volatile markets. If all asset classes are moving in tandem, the power of diversification is lost. This is the reason for the now-popular characterization of market action over the past several years as “risk-on/risk-off” trading, and HFT has undoubtedly been a factor in this phenomenon.”

We recommend that you read the entire letter as Ms. Sonders hits on many more points including leveraged ETF’s, “layering”, “spoofing” and “quote stuffing”. No doubt the cat is now out of the bag. For years, the industry has tried to keep HFT a secret and dismiss its critics as luddites and anti-technology. They have tried to squash any debate with the same old tired HFT defenses that they shrink spreads and add liquidity. They have organized an army of academics, exchange officials and lobbyists and mobilized them at the sign of any attack on their secretive corner of the market. Well, sorry guys, the gig is up and everybody knows it now. As Ms Sonders writes, “Over the past couple of months, it’s become apparent that this new type of institutional trading is a big concern of individual investors and it’s a hot topic at client events at which I’ve spoken.”

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