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Should we worry about high-frequency trading?

Date September 4, 2012 - 4:50PM 21 reading now


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Scott Phillips






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Ever since the meltdown at the US firm Knight Capital last month month, the debate over high-frequency trading has exploded.

In short form, high-frequency trading is a flavour of trading that leverages computers and the speed of super-fast data connections to make lightning-quick trades, and lots of them. This means that, often, the trader's servers are situated in the same data centre as the exchange's servers.

While there's no single strategy of a high-frequency trader – they might be acting like a market-maker, or playing index arbitrageur – the common thread is that they all rely on speed to succeed.

So, the billion-dollar question is: is this type of trading a major risk for markets, or closer to a non-factor?

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At the end of the day, if you're buying a piece of a company to own it for a long period of time, your primary concern should be the dynamics of the business, not the technical stockmarket action. Most readers have likely heard the Warren Buffett quote: "I buy on the assumption that they could close the market the next day and not reopen it for five years."

Do we want the market shut down?

Keeping in mind the fact that we're ideally buying companies and not just tickers, we should still want a healthy, properly functioning market that allows us to transact. And there are some signs that high-frequency trading is doing a lot to gum up the markets and cause some serious problems.

The US market data-collector Nanex has been on a warpath against bad practices among high-frequency traders. Specifically, they're concerned about the proliferation of quotes by high-frequency traders.

When you log on to a broker's site to make a trade, what you see listed under the bid and ask are quotes – that is, somebody offering to buy or sell at a certain price.

As the high-frequency trading industry has grown, the number of quotes has exploded – and, mind you, we're talking just quotes here, because actual trading has not grown anywhere near as much. The reason that high-frequency traders are putting out this many quotes isn't entirely clear.

In some cases, it may simply be offering and cancelling quotes the same way any market-maker would; but in other cases, it may be programs sending out odd quotes in an effort to mislead other market participants – think Muhammad Ali pulling a rope-a-dope. In some cases, Nanex has even suggested that high-frequency traders send out a barrage of quotes to create a sort of informational fog of war that gives them a brief trading edge over other participants.

The problems created by this quoting aren't just in the abstract. Here are a few concrete potential outcomes from this flood of quotes:

Cost: Exchanges and brokers need to process, manage, and store market data, so as the volume of quoting activity rises, that increases the data-processing burden. That means costly servers, routers, switches, and storage devices. While computerised trading has done much to reduce the cost of trading, there's a concern that this data overload threatens to reverse that trend.

Scaring away liquidity: High-frequency and many other types of traders are, understandably, reluctant to trade when they believe they're getting a bad data feed. When a rush of quotes hits the market, it has the potential to slow everything down, create corrupted feeds, and cause liquidity providers to bow out.

Figuring out what the heck is going on: In the wake of the Flash Crash, it took US regulators months to put together the forensic trading data from just a single day. Technology is clearly a boon to the markets but, when things go wrong – and they will, regardless – it's essential that we have a system that regulators can quickly and easily navigate.

THE DISAPPOINTING ANSWER

It would be nice if there were an easy, pat answer to this issue like "ban high-frequency trading" or "high-frequency trading is a non-issue". Unfortunately, there's not.

What we need is for regulators to dig into the problem, figure out what's going on – who's playing by the rules and who isn't – and set rules that will allow us to take advantage of the latest technologies in the financial markets without the threat from ne'er-do-wells who abuse those technologies.

Government regulators, however, aren't known (and lack the budgets) for swift manoeuvring. In a race between traders who work in microseconds, and regulators who work in weeks, months, and years, it seems reasonable to worry that regulators might remain a step behind.

FOOLISH TAKEAWAY

There are a couple of issues at work here. From the perspective of fairness and to ensure nothing untoward is happening, it's vital that our regulators get a handle on what's going on. After all, anything that tilts the game further against individual investors should be anathema to investors and ASIC alike.

Secondly, though – be Foolish. Take Buffett's quote to heart. Trade less frequently and only buy or sell when you get the price you're after. You don't have to play the high-frequency traders at their own game.

You think Warren Buffett worries about high-frequency traders? Me neither. That's a pretty good yardstick in my book.

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Scott Phillips is a Motley Fool investment analyst. You can follow Scott on Twitter @TMFGilla. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).


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