Buried deep in the UK Foresight report on computer trading in financial markets is a paper titled “Impersonal efficiency and the dangers of a fully automated securities exchange” by Daniel Beunza of the London School of Economics . This is what you may call a “common sense” paper. Rather than rattling off streams of mathematical formulas like most academic papers on high frequency trading love to do, this paper takes a step back and identifies new types of risk that have entered the market now that humans have basically been taken out of the market making process. The authors identify three areas of risk in our now almost fully automated market:
1- Risk of Weak Norms – “The application of impersonal efficiency may bring about a weakening of market norms. This includes the danger stemming from anonymous trading and the reduced scope of authority for exchanges to shape their order matching procedures.” The authors say that market participants will find “it easier to disregard market norms”. In other words, market participants will not be hindered by honor or reputation and will hide behind their machines. Reputations which took years to build are now almost meaningless since there is little to no self-policing going on anymore. The authors talk about something called the “broken window” effect. It says that once a mild form of unruly behavior is tolerated and visible, social actors tend to modify their behavior and become disorderly as well. “Consider a building with a few broken windows. If the windows are not repaired, the tendency is for vandals to break a few more windows. Eventually, they may even break into the building, and if it’s unoccupied, perhaps become squatters or light fires inside.” There is no doubt that our stock market has plenty of broken windows and the HFT market makers have decided to squat in it.
2- Risk of Toxic Transparency – “A market designed around the principles of impersonal efficiency runs the risk of discouraging participation and thus limiting liquidity. The shift towards electronic screens and transparency runs the risk of being self-defeating. This risk is clear, for instance, in the rise of dark pools.” The authors are afraid that the quest for speed and profit has hurt the price discovery process.
3- Risk of Fragmented Innovation – “By transferring markets to the electronic medium, the competitive field (has) narrowed down, driving innovation to compete primarily on achieving higher and higher execution speeds. This can lead to an increased importance of secrecy and to the emergence of a market comprised of different actors using different platforms with different technical requirements.” This is becoming more and more evident as the large HFT players start to pull away from their small HFT brethren. The authors make this very strong point:
“Knowledge-intensive competition will develop, which will make profits contingent on the production and control of proprietary knowledge. The algorithms associated with high-frequency statistical arbitrage are an extreme example of this, having a half-life of between one day and two weeks, as they are often discovered by competitors through reverse-engineering strategies. These short time frames reveal the sensitivity of information that characterizes today’s markets. It is therefore not surprising that fragmentation has resulted in an overall disincentive for cooperation, leading participants to develop a “tunnel vision” of the financial landscape.”
The hunt for profit in this latency sensitive arms race leaves every participant for themselves. These automated high frequency participants may try to fool themselves and the public by saying they are shrinking spreads and adding liquidity. But they know they are just riding this train as long as they can and milking every last drop of profit out of it before moving on. And here is where the authors really nail the problem with the current market structure:
“The continued pressure towards decentralization induced by the erosion of the current price formation centres may well result in a diminished capacity to raise capital in the primary market.”
For those that say technology is unstoppable and we can’t put the genie back in the bottle, we recommend that you read this paper. For those that think that HFT is the only way for markets to exist now and humans are no longer needed, we recommend that you read this paper. And for those that say you can’t put the toothpaste back in the tube, we say that you should not surrender so easily and you should think about the consequences that a fully automated market has on price discovery and capital formation.