(Originally Posted on December 2, 2010)
Proponents of high-frequency trading claim that their trading activity increases market liquidity. The idea that high-frequency trading adds liquidity to the markets is pure folklore, these proponents seem to confuse indiscriminate high speed trading for genuine liquidity.
The NYSE Euronext defines liquidity as, “Depth of market to absorb buy and sell interest of even large orders at prices appropriate to supply and demand… Liquidity is one of the most important characteristics of a good market.”
Years ago I made markets in illiquid over-the-counter securities, these were companies that had very few shares outstanding and traded by “appointment only.” One stock that I traded was Nantucket Electric Co., which generated and distributed electricity to the island of Nantucket. There were only 28,000 shares outstanding and they traded very infrequently.
In the early 1990s I bought 75 shares of Nantucket Electric. I re-offered the shares to investors that had an interest in the company and didn’t get any bids. To get rid of the stock I resorted to placing an advertisement in the local Nantucket newspaper. Fortunately a vacationing hotshot investment banker from New York bought the stock so he could have the certificate framed for his office.
Unlike the illiquid over-the-counter securities that I traded, trading on the New York Stock Exchange has always been known as the most liquid market in the world. For centuries stocks changed hands on the NYSE via a double auction system with specialists and traders matching buyers and sellers.
Regulatory changes in the 2000s did away with the specialist system and gave birth to new alternative trading systems or ATSs. These virtual electronic exchanges compete with each other as well as with the existing exchanges, which also adopted electronic trading systems. With these changes came a new way of trading securities that has become known as high-frequency trading.
High-frequency traders use ultra high speed computers to identify and execute trades and are capable of executing thousands of trades a second across various exchanges. This rapid fire trading generates nominal per share profits but the volume is so large that it’s highly profitable. It’s estimated that 50-75% of total equity trading volume is attributed to high-frequency trading. These traders include large well-known investment banks and hedge funds, as well as lesser-known trading firms.
In days gone by, broker-dealers and investment firms were located close to stock exchanges for logistic reasons, trades were settled by physically exchanging certificates and payments via runners. Today, high-frequency traders seek to get their computer equipment installed as close to or in some cases co-located in the exchanges or ATSs in order to trim a millisecond or two off their execution times. High-frequency trading is all about speed. A millisecond is an eternity in the world of high-frequency trading, by way of context it takes the average person about 300 – 400 milliseconds to blink.
Illusion of Liquidity
High-frequency traders don’t absorb securities for a meaningful amount of time, they typically only commit capital for a matter of moments before they indiscriminately sell the securities right back in the market place. Unlike my Nantucket Electric trade, where I held, or absorbed, the stock in our firm’s trading account until I could find a buyer, high-frequency traders often buy and resell the same securities to each other until they eventually get into the hands of a fundamental investor. The SEC/CFTC Flash Crash Report describes this rapid fire back and forth trading activity as the “hot potato volume effect.” High-frequency traders may help facilitate order execution, but make no mistake, they don’t provide true liquidity to the market place.
High-frequency trading played a central role in the May 6th flash crash. These trading systems are programmed to quickly detect unusual trading activity and automatically shut down (which is what happened during the flash crash). In other words, when the markets need liquidity the most high-frequency traders head for the hills. Abruptly pulling the plug on this kind of high volume trading at a time of market stress is highly destabilizing and creates violent market swings, ultimately damaging investor confidence.
High-frequency traders are extremely secretive about how their proprietary systems work. It’s ironic that the regulatory changes that swept in the era of high-frequency trading were chiefly driven by large mutual funds that claimed that the NYSE specialist system was unfair and not transparent. Fidelity Investments’ Edward “Ned” Johnson was one of the most vocal critics of the NYSE specialist system (at the time of the changes Fidelity accounted for about 3-5% of NYSE trading volume).
Fidelity and other large mutual funds companies pushed for the changes largely as a way to improve their funds’ investment returns by cutting costs at a time when low cost index funds were quickly gaining acceptance. Additionally, many actively managed mutual funds attracted so many assets that their portfolios had become unmanageable and the new high tech trading systems promised to improve liquidity.
From our perspective, high-frequency traders don’t bring anything to the party. Trading volume for the sake of trading volume or the speed at which high-frequency traders can trade with each other shouldn’t be mistaken for real liquidity. High-frequency trading is far less transparent than the old specialist system and undermines the stability of our markets.
High-frequency trading is very profitable for trading firms with unlimited technology budgets, however we fail to see how fundamental investors genuinely benefit from this activity. Turning the equity markets into a high stakes video game doesn’t create real liquidity. Personally, I’d much rather trade an odd-lot of Nantucket Electric than sit in front of a computer screen all day while it spits out tens of thousands of seemingly mindless trades.