What does high-frequency trading do to the markets?
Computer-generated trading was a key factor in last year’s ‘flash crash’. Yet high turnover and high volatility is not the only effect
guardian.co.uk, Thursday 6 October 2011 11.19 BST
Wall Street, 6 May 2010. The Dow Jones index – the barometer of share prices in the US – crashed by almost 1,000 points, the equivalent to 9% of its value. Shares in Procter & Gamble – a blue-chip household name – fell from $62 to $39 in five minutes before rebounding. The index eventually closed 348 points lower after it halved the huge loss in just 30 minutes.
The vast move served to compound the fears that were already gripping global markets. But when the results of an investigation into the event were published in September 2010 it turned out that the dramatic downturn was not really driven by fear or doom.
Among the factors identified in what became know as the “flash crash” was “high-frequency trading”. This HFT is an automated way of trading. Complex algorithms – known as black boxes – scrutinise patterns in markets to generate trading strategies which are automatically sent to the market by the computer.
In a speech in July, Andy Haldane, a senior policy marker at the Bank of England, commented on the extraordinary speed at which the trades are conducted. He noted that HFT increased the turnover of trades and reduced the timescale on which securities were held. “New trade technologies have progressively raised the speed limit for trading. Today, this is measured in micro-seconds – millionths of a second. Tomorrow, it may be measured in nano-seconds – billionths of a second. There is effectively a ‘race to zero’ among trading technologists, as market advantage lies in being the fastest,” he said.
“This means it would in principle be possible to execute around 40,000 back-to-back trades in the blink of an eye. If supermarkets ran HFT programs, the average household could complete its shopping for a lifetime in under a second.”
While he noted that high-frequency trading could add liquidity to markets and reduce the difference between the price at which customers want to buy and sell, known as the bid-ask spread, he also noted that there was evidence of increased volatility in markets since 2005 – and perhaps of more concern to him, a correlation between markets.
While the focus has been on the Dow, data from the central bankers’ bank, the Bank for International Settlements, show that high-frequency trading accounts for around a quarter of daily currency trades. The BIS reckons that there is evidence that the rise in such trading strategies has led to an increase in turnover in the markets.
Haldane is among those who reckons “circuit breakers should be installed in markets to avoid another ‘flash crash'”.
“We do not need to await a second flash crash to establish it was no fluke,” Haldane said in July. “The flash crash was a near miss. It taught us something important, if uncomfortable, about our state of knowledge of modern financial markets. Not just that it was imperfect, but that these imperfections may magnify, sending systemic shockwaves,” he added.
As with many events in the markets, the flash crash was not as simple as pinning all the blame on high-frequency trades. The official US report also noted: “Whether trading decisions are based on human judgment or a computer algorithm, and whether trades occur once a minute or thousands of times each second, fair and orderly markets require that the standard for robust, accessible, and timely market data be set quite high. Although we do not believe significant market data delays were the primary factor in causing the events of 6 May, our analyses of that day reveal the extent to which the actions of market participants can be influenced by uncertainty about, or delays in, market data.”
Haldane’s argument is that this ever-increasing speed of trading is not adding to liquidity in markets during times of stress but amplifying the problem – as appears to have been the case during the flash crash when he said there were delays in sending price quotes on 1,000 stocks.
With markets still in a heightened state of anxiety, the authorities are aiming to avoid another flash crash. In the UK, the government set up a review of computer trading in November 2010 under Treasury minister Mark Hoban called the Foresight project, which is being conducted by the government office for science. Haldane is among those overseeing the project, which recently published a working paper to kickstart the debate. In the introduction, the chief scientific adviser, Professor Sir John Beddington, notes: “The volume of financial products traded through computer automated trading taking place at high speed and with little human involvement has increased dramatically in the past few years. For example, today, over one third of United Kingdom equity trading volume is generated through high-frequency automated computer trading, while in the US this figure is closer to three-quarters.”
The outcome of their work, however, will not be known until the autumn of 2012.
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