We’ve been critical before about high-frequency trading. While regulation sometimes makes matters worse, it’s encouraging that he U.S. Senate Committee on Banking, Housing and Urban Affairs held a hearing this week to discuss potential regulation of computerized trading.
While it is unlikely to take action anytime soon, testimony given at the hearing was enlightening. Here are a few excerpts:
David Lauer, Market Structure and HFT Consultant, Better Markets, Inc.:
“The sophistication of your trading strategy is no longer a defining characteristic of its success, rather the number of microseconds that it takes your software to react to a piece of market data has become one of the most important factors of success in the HFT industry.”
“The traditional mantra of the high-frequency trading industry is that HFT has helped to decrease trading costs by providing tighter spreads and lower volatility. One of the oft-cited studies in support of this claim was authored by employees of RGM Advisors, LLC, a prominent HFT firm. Another study was done by an employee of Credit Suisse, a major proponent of HFT. However, an increasing number of independent academic papers have demonstrated the opposite:
– the structural inefficiencies present in the market have created a massive misallocation of resources into technology that provides no social benefit, and structural deficiencies in market structure have allowed for nefarious or accidental actions to disrupt the market.”
“The increasing fragmentation of the marketplace and the advent of pay-for-order-flow deals have led to a phenomenon called adverse selection. This means that profitable trades (from a marketmaking perspective) never reach the market. Retail and institutional order flow pass through a gauntlet of internalizers and high-frequency trading desks, which pick off any profitable order flow before it ever reaches the public market. While these orders are filled within the NBBO, meaning that the originator of the order is no worse off on that particular order, market quality as a whole suffers. Natural buyers and sellers are virtually nonexistent under this structure, and the majority of the volume on the exchanges becomes ‘toxic flow’ an industry term for orders that nobody wants to interact with.”
Larry Tabb, CEO, The Tabb Group:
Have the high-profile computer trading failures over the past year, such as the recent trading problem at one firm that sent stocks sharply higher and then lower over a period of minutes, discouraged ordinary investors from participating in the stock market? Have these failures and recent volatility with initial public offerings discouraged companies from taking advantage of the capital markets?
Of 260 market professionals surveyed by the Tabb Group two weeks after the recent Knight Trading meltdown, 34% rated their confidence in the markets as being either poor or very poor. That’s up from 15% following the “Flash Crash.”
According to Tabb, HFT is just one of many factors, including “the long-term trend of decreasing equity ownership, a reduction in IPOs and lack of trading volume across virtually all financial products.” Consider the other factors he cites:
The election – going back over previous election cycles from 1950, third-quarter equity trading volume during election years is down an average of 17% compared to the first half of the year. In non-election years, it is down only 4%. Volume in the fourth quarter during election years is down 5% from the first 3 quarters, while fourth-quarter volume during non-election is only down 3%.
Washington unease – the debt ceiling, the fiscal cliff, tax rates, and credit rating downgrades have investors uncertain about how to plan for the future.
Regulations – with Dodd Frank and many European regulatory initiatives in the works, it is hard for financial institutions to know how to plan.
Sarbanes-Oxley – raises the cost of becoming a public company. This was addressed in the JOBS Act for smaller organizations.
Research settlement/research business model – Because of the Spitzer Research Settlement, it becomes harder to fund equity research, and without equity research (even biased research), it becomes harder to discover opportunities in smaller companies.
Basle III – new capital requirements increase the cost of capital, and with interest rates so low it is hard for banks to generate an adequate return. This makes it harder for banks to provide capital to the market.
Europe – with the Euro zone threatening to break up, investors do not know how to react or invest.
Risk on-Risk off/high correlations – with all of the macro risk in the market, investors are not investing in companies, they are investing in sectors and geographies via ETFs. So investors are not worried about
Coke or Pepsi or Ford or GM, they are worried about US or China, technology or health care. They are then using ETFs to express those strategies. Because ETFs are generally index-driven, they don’t buy undervalued assets and sell overvalued assets – they buy all the assets in an index in relation to the weighting of stocks in the index. Those trading strategies then drive the correlation of assets within the index toward 1.00. Instead of one stock appreciating and the other depreciating, both begin to move in the same direction. This hurts single-stock investors who then switch their investing strategy away from single names to trading sectors, or global macro themes.
Low interest rates – with interest rates so low, and declining over the past 30 years, at some level it becomes more beneficial to borrow money instead of issuing stock and diluting owners’ capital.
Demographics – baby boomers are retiring and want to secure their retirement by moving assets out of equities into fixed income or into savings accounts
Bank consolidation – with bank/broker/investment bank consolidation, the fees generated on smaller IPOs become immaterial. As banks get bigger, they need bigger transactions to move the dial.
Private equity – is tapping institutional money to invest in private companies because the return on public companies is so low and interest rates are so low. Tax treatment of PE firms may also play into this.