The HFT School Of Fish

A new paper by Austin Gerig of the University of Oxford titled “High-Frequency Trading Synchronizes Prices in Financial Markets”  is likely to be waved around by HFT proponents as proof that they are actually performing a useful service to the markets.  But if you take the time to read past the first few sentences, you will find that the paper is actually a very stark warning about how HFT has actually has helped to misprice assets and how HFT will exit the market quickly in times of market stress.

The paper states:  “Although price synchronization is normally beneficial in markets, it can also have harmful effects. When prices are tightly connected to one another, localized errors quickly propagate through the financial system. In addition, there is potential for incorrect relationships between securities to be enforced, making prices more (or less) correlated than economic fundamentals warrant

So much for the efficient market hypothesis.  The above statement is saying that stock prices are no longer based on the individual fundamentals but are now based on correlations within the stock market.  The advancement in technology over the past few years has allowed HFT firms to synchronize prices of different stocks even if the fundamentals don’t justify the price.

Even more troubling than the mispricing of assets is the following statement from the paper:

During times of market stress, HFT firms are impelled to leave the market if their systems observe events outside the parameters they are programmed to handle – a circumstance that causes liquidity to disappear at the precise time it is needed the most…The end result is a financial system that becomes unstable during times of stress and behaves very much like US markets did during the Flash Crash.”

The author of the paper also makes a very interesting comparison of synchronization in financial markets to a school of fish:

A simple example is a school of fish. By synchronizing their behavior, fish can scan their environment using “many eyes”, which allows them to quickly evade threats or move towards potential food sources.  Financial markets are similar. In markets, the state of the economy is monitored by a large number of investors who quickly broadcast any changes to each other and the rest of society via price movements. By synchronizing prices, HFT allows the “many eyes” of different investors to function as one coherent group, which results in price trajectories that look like the motions of schooling fish. “

However, there is a problem with this school of fish behavior that the financial markets exhibit: “synchronization can have harmful effects; shared misconceptions among individuals in a group are amplified when behaviors are synchronized.”  Think Flash Crash here and also the hundreds of mini flash crashes that we have seen this year.

How can the market behave like a school of fish?  Wouldn’t the traditional forces of supply and demand alter this synchronization issue?  Not really.  And the reason is because most volume on the tape today is HFT related and has nothing to do with the fundamentals of a company.  Also, today’s market is dominated by ETF’s that simply track indexes.  Stock pickers have largely been replaced by ETF’s which further exacerbates the synchronization issue.

Unfortunately, we have seen all too often lately that when negative news hits a particular stock, the reaction is usually violent.  It is not uncommon to watch a stock drop by 10%, 20% or even 30% just because of a small miss in earnings.  Many investors are usually stunned by these rapid reactions and are left wondering how the market could not have helped predict such an event.  The weak stock was just swimming along with the school and was the beneficiary of price synchronization, until it was exposed and left to swim on its own as the school swam away.