Can high-frequency trading cause the next market crisis?

Put another way, do they heighten the risk of an imbalance in the market, such that a meltdown is inevitable? This is the latest article on high-frequency trading titled “Trading Shares in Milliseconds” published by Technology Review. (HT Tyler Cowen).

Just five years ago, automated trades made up about 30 percent of the market, and few of those moved as quickly as today's trades do. Since then, however, automated trading has become much more widespread, and much quicker. ….estimates that high-frequency automated trading now accounts for 61 percent of the more than 10 billion shares traded daily across the numerous exchanges that make up the U.S. market…With the rise of automation, the bulk of U.S. stock trading has moved from the once-crowded floor of Manhattan's New York Stock Exchange (NYSE) to silent server farms run by exchanges and broker-dealers across the country.

We see two sides of the argument in the article. One side says they mostly engage in ‘market-neutral’ strategies. This means their positions are always balanced, and that they mostly act as hyper-efficient intermediaries who are better than human traders at finding, and revealing, the lowest selling price of sellers and the highest buying price of buyers.

Funds running quantitative strategies are mostly market neutral. When we take a position, we're always balanced somewhere else, and when we unwind, it doesn't affect the market either." By this he means that forced selling by quant funds may be painful for the funds themselves, but that pain is barely reflected in the market, because the funds' long and short positions--positive and negative bets on the direction of given securities--cancel one another out. "We don't take from the retail guy," he says. "We make the market more efficient. Things are better for the retail investor because of high-frequency trading."

…….high-frequency traders are making money by delivering a service: liquidity. In today's highly decentralized market, defenders say, their systems are simply the most efficient way to match buyers and sellers. And because they can capitalize on small differences between the prices at which a seller is willing to sell and a buyer is willing to buy, those differences stay small.

……"There is risk, definitely, but quant funds like us take it all," he says. "If a quant meltdown happens, it won't affect the retail investor."

On the other side of the argument, experts say that high-frequency trading increases the volatility of the market , particularly if there are numerous competing high-frequency programs employing the same strategies, acting on the same triggers, and doubling up on the same positions.

The increasing dominance of algorithmic trading and the growing speed of execution….could cause tiny price changes to snowball, rolling down the hill at exponentially increasing speed--either because the machines are trading too fast or because too many funds are trading in the same style.

….regularly see algorithms executing more than 1,000 orders a second. At that rate, one algorithm trading the wrong way could execute 120,000 orders in two minutes. At 1,000 shares per order and an average price of, say, $20 a share, that's $2.4 billion in unintended trades. In his letter, Jacobs warned of "the potential for trading-induced multiple domino bankruptcies."

……Many now blame that crash on simple automated "portfolio insurance" systems, which were meant to keep a fund's holdings from losing more than a preset amount of value by automatically selling shares when the price dropped by a certain amount. They had their roots in a practice used by floor traders: the "stop loss" order, which initiates the sale of a given share if it falls below a given price. But the herd of computers issuing stop-loss orders created a stampede that pushed the then-dominant floor traders to sell as well. Donefer worries that if such a sell-off happened now, it would happen many times faster.

So where do we stand? In my opinion, it depends on whether you follow the “Efficient Market Hypothesis” or you follow George Soros’ “Theory of Reflexivity”.

Here are the quick wikipedia definitions. Efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly change to reflect new information. Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

Reflexivity asserts that prices do in fact influence the fundamentals and that these newly-influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles

A current example of reflexivity in modern financial markets is that of the debt and equity of housing markets. Lenders began to make more money available to more people in the 1990s to buy houses. More people bought houses with this larger amount of money, thus increasing the prices of these houses. Lenders looked at their balance sheets which not only showed that they had made more loans, but that their equity backing the loans—the value of the houses, had gone up (because more money was chasing the same amount of housing, relatively). Thus they lent out more money because their balance sheets looked good, and prices went up more, and they lent more.

Throughout the rise in the use of derivatives, the finance engineers who dreamed up ever more complicated structures claimed that their creations were eliminating risk from their financial transactions. Because the complicated structures usually incorporated the hedging of particular risks with what they believed were securities with offsetting risk characteristics, they sincerely believed, and preached, that their endless innovations were responsible for increased market efficiency and the great moderation in economic volatility. Now we know what they did was just transferring the risk somewhere else. And because of the added ingredient of leverage, the risks they thought they were eliminating were actually being magnified.

We could see the same pattern of events developing with high-frequency trading. While many first movers have heavily employed ‘market neutral’ strategies, which improve market efficiency, the entry of more competitors ensures that declining returns on the original market neutral strategies will drive more players into open-ended and speculative positions - those that stand to gain from the market’s movement in one particular direction. You can be sure of what happens next when it turns out that many of them have been piling onto the same strategies and positions. Just as the magic of growing leverage increased the havoc wrought by derivatives, so too, in my opinion, the magic of increasing speed will heighten the havoc to be wrought by high-frequency trading.

If you’re one of the little guys, and are still heavily invested in the stock market, get out now.