High Frequency Trading Defined and Discussed
The March 30, 2014 broadcast, Is the U.S. stock market rigged?, on the CBS News program, 60 Minutes, put high frequency trading on the public agenda. We discussed that program in the last White Top View, Exposed! Market Rigging and High Frequency Trading. The informative 60 Minutes investigative report also had White Top View readers asking questions. Today, we begin looking deeper into high frequency trading and how and why it affects you. This blog post continues the White Top View Series, High Frequency Trading. The series began with, Exposed! Market Rigging and High Frequency Trading. That post links to the CBS News program, 60 Minutes segment credited with putting the high frequency trading issue on the public agenda. Links to the all parts of the White Top View Series, High Frequency Trading are at the end of this post. High Frequency Trading (HFT) describes a well-intentioned stock exchange rescue strategy. A basic strategy erupted into a hyper-technology monster run amuck and now producing incredible unintended consequences. HFT combines powerful computers, cutting edge communication technology and complex proprietary programing algorithms. Together they generate, process and trade huge numbers of stock transactions at very fast speeds. HFT combines high-end hardware, secret software and most critically, preferentially favorable access to stock exchange processors, data and communications. That produces huge real competitive advantages over any and all other traders and investors. Access, speed and programming all give advantages that produce great profits for these blindingly fast systems. Incredibly, these systems can see the orders and trades of all other players before they fill or complete! HFT firms can, and consistently do, move themselves to the head of the line. HFT programs can trade ahead of all other buyers and sellers to profit from most trades throughout in the market. That puts you and every other trader or investor are at a great disadvantage. Even huge pension funds, institutional traders and the savings of nations are at a disadvantage to HFT firms.
How High Frequency Trading Happened
Nobel Prize-winning author John Steinbeck’s Of Mice and Men comes to mind. This novella, published in 1937, is known as the source of the quote, “The best laid schemes o’ mice an’ men / Gang aft agley.” (The best laid schemes of mice and men / Often go awry.) Mice, men and awry outcomes or unintended consequences too often happen when hurried schemes get hatched in a crisis. High Frequency Trading grew directly from responses to the financial crisis of 2008. A brief version of that back story follows.
2008 Market Meltdown
In response to the financial crisis of 2008, the U.S. Government Treasury and Federal Reserve Board under Chair, Ben Bernanke, took the lead in aggressive and unprecedented international economic intervention. The alternative to taking such action and providing massive economic intervention and stimulus was watching the world plunge into an economic depression. Significant businesses and multiple major banks received huge amounts of financial support, but not all.
Lehman Brothers Bankruptcy
Major banking player, Lehman Brothers, long known for aggressive market behavior, was not supported in the bailout of financial players. It collapsed, bankrupt. Billions of dollars turned to smoke. Thousands of jobs evaporated. Fear ran rampant through global banking, credit and all stock markets.
Market Liquidity Vanishes
One direct result was a liquidity crisis in stock markets. Share trading volumes all but dried up. Few had the courage to trade or invest. The few interested in trading wanted to sell and raise cash. But to raise cash, sellers need buyers. To function well any market needs many buyers, sellers and volumes of both transactions and shares. In a liquid market, buyers or sellers can easily and quickly exchange positions without substantially moving prices. Alternately, cash can readily move in or out of the market. Liquid markets occur with high levels of trading activity. Without liquidity or with low levels of trading activity, buyers and sellers have difficulty exchanging positions and can readily move prices on low volumes. Moving cash in or out of the market also becomes much more difficult in illiquid markets. A direct and immediate response to the 2008 financial crisis was buyers disappeared. Liquidity dried up.
Option Market Example
Years before the 2008 crisis, unlike many stock exchanges, options markets had switched to electronic trading. As a result, transactions substantially sped up. More transactions happened faster. As importantly, more players had more timely information. That increased competition, narrowed price spreads and as volumes rose, volatility fell. Price spreads are the difference between the price a buyer bids or offers (the bid price) and the price a seller asks (the ask price). The electronic trading system allowed all buyers, sellers and observers can see the full range and depth of bid and ask prices. With more information, and the ability to see what all others are bidding and asking, all players have better and more complete information. All parties can make rapid and well-informed pricing decisions. Volatility, the speed of price swings, declined sharply as all players had much more information at the same time. Price swings did continue, but most often were considerably less extreme. This happened because all players quickly had a more complete picture of the market. All players can see the actions and reactions of all other players. Stock exchange leadership looked to technology for a solution for the challenges presented by the 2008 crisis. Perhaps using technology could produce liquidity and bring the other advantages experienced by the options markets. That could help the market and all players. It looked like a promising answer and a way to bring investors back to the markets. Supplemental Liquidity Providers With a long proud history and rich tradition of floor trading between human specialists, the New York Stock Exchange (NYSE) was far less than enthusiastic about embracing any move to electronic or digital technology. Prior to electronic trading, orders to buy or sell stocks were slips of paper actually routed to the trading floor. Each company listed on the exchange had a Designated Market Makers (DMM) assigned as the point of contact for that particular stock. Together with the Trading Floor Brokers, they provided liquidity. Stock exchange volumes were the real orders from real investors to buy or sell shares. The 2008 financial crisis changed that is a hurry. Fallout from the crisis, the Lehman Brothers bankruptcy and absence of trading volume posed a major threat to profits that quickly changed outlooks. Motivated to find liquidity, and encouraged by the option market experience, beginning in 2009, the NYSE broke from history and offered trading incentives. A program dubbed, Supplemental Liquidity Providers (SLP), provided an incentive of $0.0015 as a fee reduction or rebate to companies that provided liquidity. In theory, SLP combined with the existing DMM and Trading Floor Brokers would deliver the desired liquidity. That is the basic background environment into which HFT emerged. At the time HFT was not only permitted but wanted, encouraged and promoted as an answer that used technology to respond to a market crisis. However, early SLP program decisions completely changed the picture, trading and the market. We discuss these outcomes in the next White Top View explaining how HFT directly affects you and your financial future.
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Links to the White Top View Series, High Frequency Trading
Part 2: High Frequency Trading and You