The High Price of High-Frequency Trading

Whatever its perceived benefits, HFT is changing the way the stock market operates.

It used to be that companies went public to raise capital; investors took risks by buying company stock, and the company and investors were rewarded when the company used its capital wisely.  The principles of supply and demand dictated stock prices, creating an efficient market in which prices adjusted based on market demand.

But HFT is affecting market fundamentals.

The majority of trades taking place today are driven not by company performance, but by tiny inefficiencies that only computers can detect.  While investors are advised to “buy and hold” their investments for years, computers are trading in nanoseconds.  High-frequency traders also buy and sell options, futures, exchange-traded funds (ETFs), currencies and all other financial instruments that are traded electronically, so its impact goes beyond the stock market.

Individual investors used to be the heart and soul of the stock market.  Today, big hedge funds and big banks are making billions of dollars off of HFT based on information that is unavailable to the average investor.  Just as small investors were hurt by the 1987 crash, while program trading gave big traders an advantage, technology again is creating an unfair advantage for big investors.

Since its introduction in 1999, electronic trading has transformed the way stock markets operate.  Other electronic trading strategies are also having an impact on the market, although not to the degree that HFT is.

We need to keep in mind, though, that computers are only as good as the information that goes into them.  Comparisons can be made to the mortgage industry.  While there were many other issues involved, the recent financial crisis began after computers took over the processing of mortgages and many unqualified people became homeowners.

Likewise, when computers do the trading on the stock market, removing the human element, mistakes are likely to happen.  The more dominant HFT becomes, the bigger the next accident is likely to be.

For more information, see my article on high-frequency trading here.

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