Time’s “Truth About High Frequency Trading”, and My Comments

Ari J. Officer, a contributor to Time Magazine,  pens this piece in Time Magazine this week entitled The Truth About High Frequency Trading:  http://www.time.com/time/business/article/0,8599,1925661,00.html

The summary: HFT is advanced market making. It makes it cheaper to trade for ordinary investors as it tightens spreads and adds liquidity. High Frequency Trading needs more competition, as the largest firms are dominating (ostensibly because they can afford the fastest connections and technology). As they are dominating, they have wiped out the smaller firms and experts. This  is not necessarily good for all investors who are not trading every second of the day.  The market may not be correctly reflecting asset pricing. A few large market makers may be controlling pricing.

I would like to comment on this well written piece, although I do not agree with all of the author’s points:

I agree that HFT adds liquidity (only in the top  large cap names). I agree that it tightens spreads (again only in the top large cap names). I will add that in my opinion it adds little liquidity in mid and small cap names. In these names liquidity is more elusive than ever, more fragmented, and trading is more volatile. I believe that one type of HFT, rebate-driven trading, tends to be in large caps and not in the smaller and “more whippy and risky” small caps, and so we don’t get the “benefits of HFT” in 98% of the stock universe. Instead, in midcap and small cap names, we see the predatory styles of HFT. Strategies that are hell-bent on sniffing out what ordinary investors, mutual funds, and pension funds are buying and selling, and stepping in front of them, are what we see in 98% of the listed equities.

Is this good? In an efficient market there is always some type of trading whose motivation is to figure out what others are doing and run in front of them. This will always be the case. But is it good for our markets when 70% of the orders and 60% of the shares traded are “non-thinking” and predatory? Is this sustainable or yet another bubble that will come crashing down in the bubblelicious America that has come to exist over the last 10 years?

The author is right, in my opinion, in questioning if today’s markets are reflecting reality with regard to asset pricing. Look at the oil markets over the last few years, and HFT’s effects on their pricing and volatility. Do we want this activity in our food markets? Our copper markets? Our stock markets? While capitalism will self-correct (we hope) this bubble too, as more players entering the field will drive down marginal profits (assuming the big boy’s lobbies dont stop this process), we ask at what collateral damage and cost to ordinary investors and consumers?

I give a hat-tip to the author for raising the potential disconnect between the market prices and actual stock values. I am pleasantly surprised at the criticism raised in this piece by an HFT insider. Again. Hat-tip.