Published January 25, 2011
By R SIVANITHY
EVOLUTION is supposed to be a natural developmental process which after completion results in the end-product being more advanced, sophisticated and somehow 'better' than what existed before.
In the financial markets, high-frequency trading (HFT) is seen as being part of natural evolution towards greater sophistication. The argument here is essentially 'faster is better' because everyone knows that time is money and speed is of the essence.
This is the preferred portrayal by investment banks, brokers and also exchanges everywhere. The Singapore Exchange (SGX), for example, announced last week it is launching the world's fastest trading engine in August as it looks to compete with other exchanges which have been busy upgrading their trading software.
Most people, however, also acknowledge that some trade-offs are inevitable in the quest for this sort of sophistication. The main one is that retail investors don't have large and powerful super-computers at their disposal and could therefore be disadvantaged. To help them, some form of regulation is needed. So it is that much of the regulatory discussion on HFT revolves around circuit breakers that would halt trading in the event of a high-speed crash.
Retail investors are also offered an alternative. For those not prepared to pit their wits against big computers which can react in a millionth of a second, they are offered passive investment in exchange traded funds (ETFs) or unit trusts, both of which are abundantly available and ever-hungry for retail business.
Our worry is that not enough thought or publicity has gone into just how radically HFT has changed the investment game. Few people realise it but unless fund and ETF managers also have super-sophisticated computers to compete on the same terms as HFT traders, they too could well be on the losing end of most trades.
Zero-sum game
According to a recent news report, traders at JPMorgan and Bank of America last year made a profit every single day for two entire quarters. How is this possible? If you accept that trading is a zero-sum game, then who lost? Most likely it was retail investors and probably a bunch of institutions which don't possess adequate computing power. Is buying unit trusts or passive investing really the ideal solution for the small investor?
To put it bluntly, circuit breakers don't offer much protection in a playing field tilted heavily in favour of HFT traders. And relying on listed, commercially-driven exchanges like SGX to formulate useful policies that would level the playing field would be a mistake because exchanges and regulators themselves are not sure what's best.
Consider that ever since the trend towards demutualisation started a decade or so ago, exchanges - like all listed companies - have been driven by a need to maximise shareholder wealth. This used to take mainly two forms: getting companies to list (and thereby collecting listing fees), and by encouraging active trading (and thereby collecting clearing fees, stamp duties, etc). Both activities were not necessarily mutually exclusive since companies that listed would be happy to see their shares actively traded.
Enter HFT, which has only one goal in mind: to make as much money as possible by exploiting weaknesses and/detecting trends before anyone else. (In the US, the average speed of a trade on NYSE Euronext is now reported to be 0.7 of a second or less, compared to 10.1 seconds in 2005 - when it was still the NYSE - while the average trade size has dropped from 724 shares to 268 shares.)
HFT traders have been described as 'valuation agnostic' - that is, they are indifferent to fundamentals or valuations and are concerned only with exploiting money flows and weaknesses.
Short-term trading
There are many strategies employed - for example, some use 'pattern recognition' (which may well be a euphemism for front-running) to detect changes in institutional flows and to buy or sell ahead of those flows while others earn rebates from exchanges for trading in high volumes; so the more liquidity they generate, the better.
However, all seek to square off their positions by the end of each session, so there is as little overnight exposure as possible.
In a nutshell, with HFT, stock markets are now predominantly populated by very short-term traders who can identify trends faster than most others and can react before the blink of an eye.
Profit-driven exchanges are keen to encourage this sort of activity because of the volume it creates and the money it adds to their coffers. But, in time, this can only lead to a near-total marginalisation of the retail investor.
More HFT may also lead to fewer good-quality companies listing since the activity does not concern itself with fundamentals - only with trends, liquidity and momentum. If so, a possible scenario is that, over time, mainly speculative-grade firms will be taken public or remain listed - which would then aggravate the short-termism already in place.
How might profit-driven exchanges like SGX then reconcile the need to ramp up trading volume by having more volume with their other role of encouraging more listings?
At this time, it looks very much that HFT benefits mainly the few - namely the large investment banks which have access to extremely powerful computers.
When you think about it, these are the same people who brought about the 2008 sub-prime mortgage crisis when they scammed the world with their new and 'improved' structured products, all of which eventually collapsed.
So does HFT really equate with evolution and its associated 'new and improved' connotations? Or is it simply another scam peddled by the big houses which have to find ways to keep their profits up?
Or, more insidiously, does one naturally lead to the other?
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