Gone are the days when specialists and exchanges with live traders dominated stock and commodity trading. These days, real people are largely out of the picture. Instead, computers in the hands of high frequency trading firms (HFTs) that run algorithms all day long have taken over the market-making function. They account for about 70% of the volume in stocks. In many cases, these firms are allowed to place thousands of orders that they soon cancel in just fractions of seconds after placing them. In fact, they locate their powerful machines very close to the exchanges in order to increase the speed at which they can place orders. At times they jump ahead of real investors because they are able to act in milliseconds. Often, these computers will not even execute a trade; they just place quotes, thousands of quotes, with no apparent intent of taking the other side of a trade.
For the last several months you have heard us discuss the fundamentals of the European debt crisis and the bursting bubble in China, but we would be remiss if we did not take time to highlight this even more basic element of the market. We find it just as troubling. And it’s compounded by market regulators who are turning a blind eye to this blatant chicanery. For the last couple years, we have marveled at the way the equity market catches a bid at about the same times on almost every trading day. This should not occur in rational markets; regular pattern should be arbitraged away very quickly as participants learn to take advantage of anomalies. But the pattern persists.
In the old days investors and traders would have blackballed firms guilty of perpetrating such shenanigans, but in most cases the HFTs operate in anonymity. To top it off, the HFTs just turn off their machines when markets get nasty, leaving real money players with nowhere to go for liquidity. The May 2010 Flash Crash and the recent calamity at Knight Capital were perfect examples of what can happen when the current market systems go haywire. It’s bad enough that one of the richest equity markets in history (based on normalized earnings) is being held aloft by fiscal frenzy and monetary mania. When you add high-frequency hysteria to the list, there is more than enough support for caution.
Scott Brown, October 16, 2012