High-Frequency Headache

Previous posts this week shared concerns from John Mauldin of Mauldin Economics about exchange-traded products and high-yield bonds. Mauldin also called out high-frequency traders, who did nothing to keep the market from dropping on Feb. 5.

While high-frequency traders no longer account for a majority of trading volume, they are still significant. In addition, an increasing number of asset managers who may not be considered to be high-frequency traders, are using computer programs to buy and sell shares automatically.

“By the way, did anybody else notice that the high-frequency traders who are always bragging about how they provide liquidity to the markets simply disappeared as the markets fell through the floor?” Mauldin concluded. “Where was this liquidity they were talking about? They have the inordinate privilege of front-running everybody’s money, taking basis points from every trade, on the theory that they are providing liquidity. And they simply withdrew it via their completely quantitatively computer-controlled system.”

So rather than benefiting the market by providing liquidity, high-frequency traders likely contributed to the sharp price decline by automatically selling in response to falling prices.

“The truth is that the market is just as irrational and divorced from fundamentals on the way up as it is on the way down,” according to The Washington Post. “It is in the nature of markets more so today than ever, as a result of the computerized high-frequency trading strategies of the Wall Street wise guys. What we watched last week is herd behavior on steroids.”

Whether or not high-frequency traders caused the sudden increase in volatility that has emerged this month is open to debate, but it’s certain that they will profit from it. With volatility practically nonexistent over the past couple of years, the volume of high-frequency trading has ebbed. As high-frequency traders thrive on volatility, they are already staging a comeback.

Some believe regulation is necessary to prevent high-frequency traders from having a major influence on the markets.

“High-frequency trading should be reined in, and any bid or ask prices submitted by computers should be made (to) last for at least 0.5 seconds,” according to Maudlin. “Slow enough for a young trader with good twitch speed to hit the button on their own computer and execute.”

Volume on the New York Stock Exchange would drop significantly, but that’s meaningless volume that isn’t there when it’s needed – as on Feb. 5.

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