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The Stock Market And High-Frequency Trading

In a March 2010 Letter The Chicago Federal Reserve examines the topic of High-Frequency Trading.

Statistics stated in the letter paint a rather interesting picture: 

"The TABB Group, a financial markets research firm, estimates that algorithmic trading in the U.S. equities markets grew from 30 percent of total volume in 2005 to about 70 percent in 2009 and that 2 percent of the 20,000 trading firms in the U.S. initiate these transactions."

There has been various debates as to the risks, benefits and consequences of High-Frequency Trading and its prevalence.

As stated in the Chicago Fed letter, one of the purported benefits is an increase in overall market liquidity.  The letter also seems to indicate most of the risk lies in the possibility of a HFT firm or system "going berserk."

I think that perhaps the most foremost risk, and one that generally receives little heed, is the nature of the (vast) majority of these trades.  These trades don't reflect beliefs about the markets or economy; instead, they seek to profit based upon arbitrage opportunites, spreads, and related issues.  In my opinion, this presents many hazards; perhaps chief among these is that should these arbitrage opportunities, spreads, etc. no longer yield consistent (and/or predictable) profits, there could be a high-speed mass exodus from the markets, creating a liquidity void, i.e. crash.

While markets have always been susceptible to crashes, this High-Frequency Trading, based upon generally unknown factors and concentrated among a small percentage of firms, seems to definitely be a potential problem area.

Previous to the stock market's Crash of 1987, "Portfolio Insurance" was hailed as a major benefits to the markets and was theoretically supposed to prevent a crash.  The situation with High-Frequency Trading seems, in many ways, to have a similar aura...

disclosure: no stocks or securities mentioned

Disclosure: disclosure: no stocks or securities mentioned