Why Don’t We Just Unplug the HFT Robots?

by Jeff Reeves | August 8, 2012 1:34 pm

Why Don’t We Just Unplug the HFT Robots?

I’m a bit baffled why, in the wake of the Knight Capital (NYSE:KCG[1]) computer-trading debacle, we continue to debate IF high-frequency trading should be limited or banned — instead of WHEN.

You know the story. A recent $400 million rescue deal[2] spearheaded by Jefferies Group (NYSE:JEF[3]) has allowed Knight to avoid disappearing in the wake of last week’s trading glitch[4]. That electronic mess affected big names like General Electric (NYSE:GE[5]) and Best Buy (NYSE:BBY[6]), and it caused a $440 million loss in roughly 30 minutes.

But it’s not the first glitch and certainly won’t be the last. I wrote about a need for HFT reform[7] back in February on InvestorPlace.com, and the financial media has been abuzz with talk for the better part of a year. Why is nothing getting done?

For the record, I do not advocate a return to ticker tape or crowded trading floors. Computer-based trading has huge benefits — as anyone who has placed a stop-loss in their eTrade account and avoided a crash can attest to.

But it’s not computer-based trading that scares me. It’s the frequency, breadth and dominance of rapid and unmonitored trading.

Look at the consequences and the risks:

In May 2010, a “flash crash” shaved about 1,000 points off the Dow in intraday trading, and megacaps like Procter & Gamble (NYSE:PG[8]) and Accenture (NYSE:ACN[9]) traded for as little as a penny per share. High-frequency trading algorithms are largely credited as the cause … but the specifics remain unknown.

In the intervening years, HFT bots have only become more prevalent. An article in The Wall Street Journal[10] in February cited a report by the Tabb Group estimating that as many as 98% of orders placed by these computers are canceled before they become trades. The result is clogged trading queues and undue stress on the system. A New York Times[11] article from 2011 says computer programs are behind “60% of the 7 billion shares that change hands daily on United States stock markets.”

Just one error could cause this house of cards to collapse. Knight proved this on a smaller scale — and since HFT algorithms are only becoming more common, there isn’t much time to lose.

While many investment banks like the practice, an outcry is growning among respected investors and financial journalists over the issue. One of my favorite commentators, Reuters’ Felix Salmon, says the rapid rise of high-frequency trading[12] has prompted him to favor some kind of transactions tax to at least slow the onslaught. Regarding HFT, “The potential cost is huge; the short-term benefits are minuscule,” Salmon writes.

Financial services firm Pragma Securities[13] has issued research that “proves” HFT is bad for retail investors. Pragma’s report, The Difficulty of Trading “Ultra-Liquid” Stocks, concludes:

“Although volume and liquidity are often thought of as synonymous, the large number of shares typically posted on the book of very high volume stocks makes it difficult to gain priority and get executed with limit orders. In the race to stay close to a benchmark and avoid adverse selection, traders must get more aggressive to escape the crowded book of competing quotes, and suffer the consequences in worse shortfall.”

And perhaps most disturbing of all, this time-lapse animated chart from the markets research firm Nanex[14] shows in gory detail just how volatile the markets have now become on a volume basis. The interactive graphic starts slow … but watch how around late 2009 — despite an utter lack of retail investors — the spikes in volume start increasing in frequency until by late 2011 the volatility is enough to make your head explode.

So, why are we still debating some kind of oversight instead of enacting it?

Earlier this year, the Securities & Exchange Commission alluded to taking on “high-frequency trading” via a few more regulations. As usual, though, there’s handwringing about how a tax would hurt an already battered financial sector and tight regulations would limit market liquidity, and nothing has gotten done as a result. There was also talk of HFT regulations in Europe a year or so, but those limits also have been tabled[15].

HFT safeguards are overdue. Let’s stop talking about them and get to work on enacting them.

It’s not too late to put the genie back in the bottle. Consider an incident from June[16] where a human “Designated Market Maker” identified a fat-finger trade and helped avert the error of a human who confused Monster Beverage (NASDAQ:MNST[17]), the energy drink giant, vs. Monster Worldwide (NYSE:MWW[18]), a jobs portal. It’s a small event, but proves the value of human cognition and manual oversight.

There’s no way to make the markets perfect and “fair” for everyone. But HFT critics, for the most part, aren’t interested in making the playing field 100% level.

They just want to prevent another disaster like the Flash Crash, or the Knight mess.

Or whatever is sure to come next, before reforms take hold.

Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.”[19] Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not hold a position in any of the aforementioned securities

Endnotes:
  1. KCG: http://studio-5.financialcontent.com/investplace/quote?Symbol=KCG
  2. $400 million rescue deal: http://dealbook.nytimes.com/2012/08/06/knight-capital-confirms-lifeline-loses-market-making-duties/
  3. JEF: http://studio-5.financialcontent.com/investplace/quote?Symbol=JEF
  4. last week’s trading glitch: http://investorplace.com/2012/08/trading-glitch-sends-stocks-scrambling/
  5. GE: http://studio-5.financialcontent.com/investplace/quote?Symbol=GE
  6. BBY: http://studio-5.financialcontent.com/investplace/quote?Symbol=BBY
  7. I wrote about a need for HFT reform: http://investorplace.com/2012/02/high-frequency-trading-is-high-tech-cheating/
  8. PG: http://studio-5.financialcontent.com/investplace/quote?Symbol=PG
  9. ACN: http://studio-5.financialcontent.com/investplace/quote?Symbol=ACN
  10. article in The Wall Street Journal: http://online.wsj.com/article/SB10001424052970203918304577239440668644280.html
  11. New York Times: http://topics.nytimes.com/topics/reference/timestopics/subjects/h/high_frequency_algorithmic_trading/index.html
  12. the rapid rise of high-frequency trading: http://blogs.reuters.com/felix-salmon/2012/08/06/chart-of-the-day-hft-edition/
  13. Pragma Securities: http://www.pragmatrading.com/sites/default/files/pragma_-_cost_of_deep_liquidity_-_press_release_final.pdf
  14. markets research firm Nanex: http://www.nanex.net/aqck/2804.HTML
  15. those limits also have been tabled: http://www.bloomberg.com/news/2012-02-13/eu-high-frequency-trades-cftc-budget-europe-trading-tax-compliance.html
  16. an incident from June: http://articles.chicagotribune.com/2012-06-29/business/sns-rt-us-nyse-marketstructure-blunderbre85s1lu-20120629_1_nyse-euronext-big-board-trading
  17. MNST: http://studio-5.financialcontent.com/investplace/quote?Symbol=MNST
  18. MWW: http://studio-5.financialcontent.com/investplace/quote?Symbol=MWW
  19. “The Frugal Investor’s Guide to Finding Great Stocks.”: http://www.amazon.com/dp/B007KB9CSI/ref=rdr_kindle_ext_tmb

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