I have subscribed to the Chicago Fed Letter for years. It's free, looks pretentious scattered on my desk along with my P. D. Q. Bach CD's and occasionally has an article I can almost understand. Recently, it has a study on high-frequency trading and whether it poses and/or amplifies systemic risks. Cutting to the chase:
The high-frequency trading environment has the potential to generate errors and losses at a speed and magnitude far greater than that in a floor or screen-based trading environment. In addition, the types of risk-management tools employed by broker–dealers and FCMs, their customers, nonclearing members, exchanges, and clearinghouses vary; and the irrobustness for withstanding losses from high-frequency algorithmic trading is uncertain. Because these losses have the capability of impacting the financial conditions of the broker–dealers and FCMs and possibly the clearinghouses, determining and applying the appropriate balance of financial and operational controls is crucial. Moreover, issues related to risk management of these technology-dependent trading systems are numerous and complex and cannot be addressed in isolation within domestic financial markets. For example, placing limits on high-frequency algorithmic trading or restricting unfiltered sponsored access and colocation within one jurisdiction might only drive trading firms to another jurisdiction where controls are less stringent. [Whole source (pdf)]
This one article was nearly over my head, but for more explanation about how this form of trading is changing the stock market, this recent story really shed some light.
The rise of high-frequency trading helps explain why activity on the nation’s stock exchanges has exploded. Average daily volume has soared by 164 percent since 2005, according to data from NYSE. Although precise figures are elusive, stock exchanges say that a handful of high-frequency traders now account for a more than half of all trades. To understand this high-speed world, consider what happened when slow-moving traders went up against high-frequency robots earlier this month, and ended up handing spoils to lightning-fast computers.
It was July 15, and Intel, the computer chip giant, had reporting robust earnings the night before. Some investors, smelling opportunity, set out to buy shares in the semiconductor company Broadcom. (Their activities were described by an investor at a major Wall Street firm who spoke on the condition of anonymity to protect his job.) The slower traders faced a quandary: If they sought to buy a large number of shares at once, they would tip their hand and risk driving up Broadcom’s price. So, as is often the case on Wall Street, they divided their orders into dozens of small batches, hoping to cover their tracks. One second after the market opened, shares of Broadcom started changing hands at $26.20.
The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.
In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing. Their computers began buying up Broadcom shares and then reselling them to the slower investors at higher prices. The overall price of Broadcom began to rise.
Soon, thousands of orders began flooding the markets as high-frequency software went into high gear. Automatic programs began issuing and canceling tiny orders within milliseconds to determine how much the slower traders were willing to pay. The high-frequency computers quickly determined that some investors’ upper limit was $26.40. The price shot to $26.39, and high-frequency programs began offering to sell hundreds of thousands of shares.
The result is that the slower-moving investors paid $1.4 million for about 56,000 shares, or $7,800 more than if they had been able to move as quickly as the high-frequency traders.
Multiply such trades across thousands of stocks a day, and the profits are substantial. High-frequency traders generated about $21 billion in profits last year, the Tabb Group, a research firm, estimates. [More] [[My emphasis]
I think we're kidding ourselves if we think some form of this type of computerized trading isn't going to be part of our markets - if it isn't already. As grain merchandisers tighten their exposure limits by handing risk costs down to growers, many will think to simply open accounts and take their own positions on an exchange. Given the nature of trading described above, that seems a little sophomoric to me.
I suspect commodity markets could become even more squirrely as quants seek new playgrounds for such trading techniques. Grain pits may not be big and deep enough for algorithmic trading to work right now, but that could be simply a matter of time and code.
Our pricing structure could still function, but only with lamprey-like costs added in as computers essentially "tax" each transaction. As the Fed notes, it is not clear how to regulate this trend, and it may be that only by duplicating or capturing such transactional costs can commodity traders at least keep the money in our value chain.
The presence of such parasitic costs also argues for increased pressure to consolidate up and down the chain to keep the transactions out of the public markets. For example, the efficiencies of packers owning cattle rise as they avoid having to shave a few cents off each buy-sell to hand to Wall Street.
Now think how some kind of scheme to "capture" grain growers for an ADM, for example, could accomplish the same thing. Throwing sand in the gears of our markets seems like a powerful incentive to avoid them.
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