The High-Frequency Trading Debate

By Paul Amery

If you’ve read any finance or investment blogs over the last couple of weeks you can’t have missed the fuss over high-frequency trading (HFT).

It’s a pretty involved story to get your head around, filled with impenetrable jargon (“low latency”, “collocation”, “dark pools”, “algorithmic trading”) and with a juicy spy scandal thrown in a couple of weeks ago when a former Goldman Sachs (GS) employee was arrested by the FBI and charged with the theft of software programmes that the bank had used for its computerised trading.

So what’s it all about? The critics – and there are many of them – hint that HFT may be open to exploitation by the big bank trading desks to make unfair profits at the expense of ordinary investors. Paul Wilmott, an academic who has popularised quantitative trading, even suggests that HFT may “distort the underlying markets and perhaps the economy”.

Others, including a trader I spoke to today, argue that the increasing use of computer-based trading programmes simply reflects the efficiencies offered by technology and new communications infrastructure, and that the cost of trading for investors remains on a declining trend overall – which isn’t a bad thing at all.

Of course, the ability to trade in very large volumes over very short timeframes confers a lot of power on the institutions that have access to these systems. But that doesn’t imply that this power will be abused. In the New York Times article mentioned above, Wilmott argues that HFT might increase the chance of destabilising feedback mechanisms leading to financial bubbles and busts, and refers to the contribution of “portfolio insurance” – a type of feedback strategy – to the 1987 stock market crash.

Whether the existence of super-powerful computerised trading programmes is destabilising in itself is debatable. A sceptic might argue that markets are by nature prone to bubbles and busts because they reflect human beings acting in crowds. Whether computing power might increase the likelihood of destabilisation depends on how the programmes are constructed. The burden of proof therefore remains with the prosecution, in my opinion.

But the debate over computerised trading brings to mind an important question about the ETF market. One of John Bogle’s major criticisms of the fund management industry has been that portfolio turnover is too high, resulting in unnecessary costs for the end-investor. With the steady decline in trading costs that we are witnessing in securities markets, is it still reasonable to suggest that an index investor should be “passive”, with infrequent changes in his or her portfolio? Or should investors embrace the brave new world of systematic, quantitatively driven, high-frequency fund management?

Original post

Comments

[Robert Martorana]

After 2008, Modern Portfolio Theory already has one foot in the grave, thanks to the simultaneous declines in every asset class except cash and T-bills. The failure of MPT, and the decline in transaction costs that you noted, is driving the asset management business towards active investing of ETFs (especially in tax-deferred accounts).
Well done, and insightful comment about Bogle. Passive management still has its flaws, namely that it surrenders any attempt at corporate governance. But the proliferation of low-cost ETFs offers the opportunity for cost-effective tactical asset allocation. And this won't go away.

2009 Jul 29 10:09 PM

[PainfullyAware]

"Of course, the ability to trade in very large volumes over very short timeframes confers a lot of power on the institutions that have access to these systems. But that doesn’t imply that this power will be abused." - Paul Amery

This statement is Very True - The Hardware And Software Is Only A Tool. Very Much Like A Fire Arm.

Humanity's Self Serving Interest Is Why It Will Be Abused.

Those on the benefit side will always defend the "Honey Stream". It is unfortunate that many Governments are indirect/direct beneficiaries.

Anti-Trust Should Be Looked Into.

2009 Jul 30 03:03 AM

[electric car]

Only in the animal kingdom is brute power allowed to prevail. Not in civilized society.

In the hands of drug dealers AK47s and viruses in the hands of hackers and ID theft criminals are "efficiencies offered by technology and new communications infrastructure" . That does not mean law enforcement officers should say we just have to live with it. Nor should common citizens be willing to accept these advances in technology and communications as unrestricted muscle power that can be used against the common good.

Unrestricted high frequency trading should not be allowed. When computer trading will completely take over social trading by humans, it will not be a market anymore..just another jungle.

2009 Jul 30 11:20 AM

[William J. McKibbin]

While high frequency trading has tremendous appeal to institutional traders and firms, its impact on individual investors is ominous. My advice to small investors is beware of the markets until regulators can level the playing field.

2009 Jul 30 12:51 PM

[S3]

The truth about High Frequency Trading--

www.s3.com/news2009-07...

2009 Aug 04 03:24 PM

[User 422955]

If the technology gives the high frequency traders profits they would not otherwise make, then these profits come at the expense of somewhere else in the economy. HFT should be outlawed until all investors and speculators have equal access to it -- perhaps through ETFs. Then, of course, any advantage will be gone.

2009 Aug 08 08:15 PM

[MarieG]

In fact the Proprietary Trading Firms are the only ones with the advanced infrastructure to link together the disparet trading venues to form 'effecient price formation' across these puddles of liquidity.

If liquidity is a valuable attribute of the stock market, then High Frequency Firms provide a true benefit.

Next question is if the 'Regression to Mean' strategy of a computer provides more liquidity in times of 'shock' than the older, human implemented market maker model.

2009 Aug 29 11:44 AM