Why High-Frequency Trading Has to Go
Jamal is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
During a recent conversation with my prior boss, a discount brokerage manager, he confided that business is not doing well. I asked him for reasons, and was shocked by his response. His answer was simple; people just don’t trust the market anymore. He felt that high-frequency trading (HFT) has eroded the average retail investor’s confidence so much that it has the potential to ruin our capital markets, and I agree.
Before I am regarded as a heretic, a Luddite, or even an alarmist circus barker, let’s consider the evidence. The flash crash of May 6, 2010 provides the most transparent example of the destructive potential of this technology. According to the International Organization of Securities Commission’s report of HFT, during a five minute period, “Many of the almost 8,000 individual securities and ETFs suffered price declines of 5-15%, before recovering most of their losses. Over 20,000 trades across more than 300 securities were executed at prices more than 60% away from their values just moments before.” However, proponents of HFT promise it promotes better liquidity and “price discovery.” Many of these proponents on CNBC would know something is amiss, if they only turned around. The once vibrant floors of the NYSE have been hollowed out, with most floor traders replaced by supercomputers hundreds of miles away.
What Is HFT?
High-Frequency Trading basically utilizes complex computerized algorithms in order to perform extremely fast and barely profitable trades. However, if this computer makes a $.01 profit on 10 thousand shares in three seconds, it is a lucrative deal. Just spin, rinse, and repeat until you are a millionaire. Many HFT acolytes liken HFT to “picking up a penny on the street.” Who does that hurt? Well, if you pick up five billion dollars of pennies, many coming from retail investors, by basically instituting a de facto investing tax on them, it’s going to hurt them.
I feel the most apt analogy for HFT is a movie theater. Imagine calling your local cinema and being told that prices for the movie are going to be $4; you quickly drive to the theater, prepared to watch a good movie. Upon arriving at the cinema, you are now told that due to the tremendous amount of phone calls and interest, the ticket price is now $5. Then, as you begrudgingly hand your five dollars to the cashier, another customer jumps in front of you, grabs the ticket and pays, turns to you and says, “Now, pay me $6.” Think of the phone calls as a technique that HFT firms employ called “order stuffing,” that allows its computer to “gum up” the exchange’s quoting mechanism to create an exploitable trading advantage; the HFT computer then scoops up your “ticket” for a cheaper price than you can get, due to its lightning fast execution speed.
Erosion of Confidence
Oct. 3 saw an extreme market open for shares of Kraft (NASDAQ: KRFT), with shares spiking over $13. How could this company surge 29% within one minute of trading? Were investors reacting positively to the recent split of Mondelez International? Was there an unexpected announcement? Did earnings signal a great quarter for the company? The answer to all three questions is no. The reason for the surge was a high frequency trading algorithm that went haywire, further undermining investor confidence in the market.
Another example of computers going awry and destroying investor confidence is the initial public offering of the social networking giant Facebook (NASDAQ: FB). In what was designed to be a triumphant moment for the stock market, and a way to say thank you to the average retail investor, something went terribly wrong. There were numerous problems with this IPO, including ever-increasing share issuance, an astronomical valuation, and user monetization problems. Unfortunately, Facebook had to address these problems much quicker than expected due to Nasdaq’s epic fail, which Eric Hunsader, CEO of Nanex, squarely placed at the feet of HFT firms.
A Square Deal
High frequency trading has taken over trading in the United States, accounting for close to 70% of all equity trades in 2010. Anecdotally, this has led to an erosion of investor confidence by “mom and pop” investors. The common zeitgeist, whether it’s the “99% versus the 1%,” Occupy Wall Street, or any other variance of the income inequality argument is based upon the fundamental premise that the average person isn’t getting a square deal, is unfortunately correct here.
What is the benefit of price discovery and liquidity if the prices discovered are manipulated and the liquidity is punitive? Yes, John Henry did beat the steel driving machine, but he lost his life in the process. Looking around the NYSE’s trading floor, and many discount brokerage lobbies, and you get the feeling you are attending his funeral.
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jcareagle has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
