High-Frequency Firms Triple Trades in Rout
The stock market's fastest electronic firms boosted trading threefold during the rout that erased $2.2 trillion from U.S. equity values, stepping up strategies that profit from volatility, according to one of their biggest brokers.
The increase from Aug. 1 to Aug. 10 over their 2011 average surpassed the 80 percent rise in U.S. equity volume, showing that high-frequency traders made up more of the market during the plunge, Gary Wedbush, executive vice president and head of capital markets at Wedbush Securities, said in a telephone interview. Wedbush is the largest broker supplying bids and offers on the Nasdaq Stock Market, according to exchange data.
"We're seeing a tremendous amount of high-frequency trading," said Wedbush, whose company is one of the biggest execution and clearing brokers catering to high-speed firms. "Their business is a trading business, and volatility creates far more opportunities. Some of their algorithms and automated systems are trading two, three or five times as many shares as they would have in a more normalized volatility environment."
The role of high-frequency firms in periods of market swings has come under scrutiny since the May 6, 2010, crash that briefly erased $862 billion from U.S. share values. In contrast to their behavior this month, the traders and other professional investors were said to have withdrawn bids as the 2010 selloff worsened, according to a Sept. 30 report from the Securities and Exchange Commission and Commodity Futures Trading Commission.
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Regulatory Probe
U.S. prosecutors have joined a regulatory investigation into whether some high-speed traders are manipulating markets by posting and immediately canceling waves of rapid-fire orders, two officials said in April. Justice Department investigators are working with the SEC to review practices "that are potentially manipulative," according to Marc Berger, chief of the Securities and Commodities Task Force at the U.S. Attorney's Office for the Southern District of New York.
Algorithms, or strategies that execute bigger orders by breaking them into smaller pieces and sending them to different exchanges, also use high-frequency techniques. Mutual, pension and hedge funds employ algorithms built by brokers or vendors to automate some of their trading instead of manually placing orders in markets or turning to humans to buy or sell blocks.
Wedbush said professionals who add bids and offers on exchanges make trading more efficient and reduce the cost to investors of buying and selling shares.
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Surges and rapid declines in the S&P 500 are being driven by institutional investors turning over baskets of stocks and investment banks hedging positions in response to actions by central banks in Japan, Switzerland, Europe and the U.S., Quast said. Institutional investments generally focus on correlation between products and asset classes whereas speculative trading is driven by divergence from historical price relationships among stocks, indexes, currencies and other gauges, he said.
"Institutions are engaged in massive efforts to transfer risk across multiple asset classes because of fluctuations in the yen, franc, euro and U.S. dollar," Quast said. His firm saw shifts in institutional money increase beginning on Aug. 4. "This is causing volume and volatility to increase, which in turn attracts volatility traders," he said. 1`
David Fuller's view In the question of which came first: the chicken or the egg - does high-frequency trading respond to volatility or is it a cause volatility? I think it is the latter.
Markets have always been much more volatile than changes in fundamental factors, because people are emotional, especially when leverage is used. Extreme volatility tends to be bearish because it frightens many investors and commentators who see it as a sign of instability. This can have economic consequences if it influences corporate decisions by making managers more cautious.
I do not think that the increase in volatility need be a problem for value investors, provided they are not influenced by it. In fact, it can help them by exaggerating moves, particularly to the downside. This increases buying opportunities.
However, increased volatility can certainly make trading more hazardous, especially for the majority of people who have little interest in sitting in front of screens, monitoring extremely short-term tick charts. In fact, that is physically impossible for anyone who wishes to monitor more than a few instruments, but the machines can do it for thousands of instruments, trading them in a frenzy of algorithmic signals.
We will never get rid of the machines, nor should we. Technology in its myriad forms marches on and is one of mankind's greatest achievements, especially when used for the common good.
However, investors and regulators may wish to consider whether or not high-frequency trading, often defended because it increases liquidity, actually reduces it when liquidity is needed most? Is it a good or bad idea for high-frequency trading to have prior access to price information? Is the industry sufficiently regulated to prevent front-running, scalping or other predatory practices?