Tuesday, November 27, 2012

High-Frequency Trading: Markets on Steroids

The purpose of the stock market is to provide liquidity to investors who know with certainty that they can buy and sell their shares at any time. In this way, the market serves as a constant encouragement to invest capital in sectors of the economy while limiting risks. Thus, the market fulfills a need in society and can contribute to economic prosperity.

However, it is no secret that the stock market has often favored reckless activities and speculation that depart from this purpose. It has given rise to crashes, manias and panics that turns this instrument of sound investment into a financial casino where everyone plays the market in hopes of cashing in at the right moment. Stockbrokers are always coming up with new ways to beat the market. Such practices are perfect examples of what has been called frenetic intemperance – a reckless and restless spirit inside modern economy that seeks to throw off all restraint.

The stock markets latest frenetic practice is something called high-frequency trading (H.F.T.). It is as if Wall Street has taken the frantic practices of markets past and put them on steroids. H.F.T. is fast taking over the market. Between 50 percent to 70 percent of all trading done today is by “traders” who are not human at all, but rather supersensitive computer programs that use algorithms to sense minute market trends and automatically buy and sell massive volumes of stocks in the twinkle of a nanosecond. Firms using these “traders” will even locate themselves close to the stock exchange in the hopes of shortening the physical distance of the binary pulses over the wire and thus get the jump on competitors.

Those who engage in high-frequency trading recklessly attempt to throw off restraints of time and space. They create great risks…and great profits by shaving off for themselves fractional cents off massive volumes of shares. It is intemperate in that it departs from the purpose of financial markets which is to provide liquidity so as to encourage confidence in long-term investment and the proper allocation of resources.

Nano-second investment does exactly the opposite. It throws everything into a frenzy. Investment becomes based, not on a company’s performance, but upon an unthinking game of competing algorithms that move the price of shares up or down based on perceived trends. There is no deliberative human judgment involved in such trading but only the electronic attempt to exploit any miniscule price discrepancies, which might appear inside nanosecond windows.

Indeed, such hyperactive trading flooding the markets has already proven destabilizing to the point that many countries are looking at ways to regulate or curtail the trade. Many market disruptions have been traced to H.F.T. The most expressive example of the damage such trading can cause was the May 2010 “flash crash” when several companies lost nearly $1 trillion after a single trading firm allegedly tried to sell 75,000 futures contracts using errant algorithms.

Practice like these lead to more volatile markets, which are in turn less responsive to actual investment value. Even Wall Street experts are beginning to question the wisdom of filling the market with these speed-ridden mechanisms. All of this reflects frenetic intemperance inside economy that points to a central moral problem deep inside the soul of modern man, which is denounced in the book, Return to Order.

1 comment:

  1. The human decision enters into it when the algorithm is designed. Human traders are still required to tweak the systems and it's really difficult to beat the ability to read an accounting form means a lot when it comes to managing capital on the various markets.

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