The whole of human experience teaches that if you want a good deal, cut out the middle man. High-frequency trading by definition is market participation with a horizon of less than a day. The middle man means more mouths to feed, and they are not the path to better deals for customers.
One could argue that a fragmented marketplace needs intermediaries or runners ferrying goods between markets. Why is it fragmented to begin with? If Walmart disintermediated mom-and-pop shops by bringing good deals to the masses, as some critics charge, should the equity market be the exact opposite?
Our mathematical models show that nearly 85 percent of market volume is a form of logistics: in other words, moving stuff around. Half is statistical arbitrage-profiting on small spreads and variable liquidity. The other half is rebalancing activity for indexes and ETFs that form a relentless tidal slosh in markets obsessed with risk exposure. Its asset management. That leaves about 15 percent thats bottom-up, fundamental investment.
With a horizon of less than a day, HFT isnt investment but arbitrage. While trading that corrects temporary value-distortion offers benefits, it shouldnt be a top price-setter. We use models to identify behaviors setting price every day in individual securities. In a mega cap, a household-name consumer-goods company, HFT was more than eight times more likely to set price in the five trading days ending Dec. 6 than was fundamental investment. Looking 20 days back, HFT was almost 20 times the price-setter of any other behavior.
Its not unique to mega caps. In the same period, HFT was again eight times more likely to set the price in a particular Nasdaq-traded small-cap biotechnology firm over five trading days, and over 11 times more likely to set price in the trailing 20 trading days. When intermediaries are vastly superior as price-setting forces to either bottom-up or top-down investment, they are distorting prices and disrupting natural function.
It doesnt end there. Often, HFT reacts violently to change in underlying algorithmic order-flow. Reactions are routinely measurable in models a day before, serving as a reliable harbinger in our analytics of impending adjustment to price-direction.
Contrary to popular belief that HFT reduces volatility, data demonstrate the opposite. A financial-services firm reported results on Dec. 10. On Dec. 11, the stock had intraday volatility-spread between high and low prices-of 9 percent. HFT was 30 times more potent as price-setter than bottom-up investment, the behavior a distant second in setting price. Bottom-up investors were pleased with results, price-setting data indicated. Yet HFT, with fractional liquidity-just 1.4 percent of total-dominated price-setting and fostered massive volatility, pushing closing price down and offering an impression to market participants of something other than the truth. It happened because indexes and ETFs, normally potent price-setters, declined on Dec. 11. In the vacuum, fast traders rapidly repriced the market to encourage action on fear or greed.
While HFT accounts for more than 60 percent of all volume (we measure not just proprietary trading but riskless-principal market making by large two-sided brokers), its but a few percentage points of liquidity at most, and in this instance not even 2 percent of it. By brutally varying the availability of that liquidity, HFT distorts market supply and demand.
This should be no surprise. HFT firms are in effect shill bidders wanting to risk and own nothing but to profit on others interest in things. They are the first to disappear when value vacuums form in markets. And with 20 times the price-setting authority of other behaviors, they present a frightening risk to market stability during crises.
Rules shouldnt promote it at the expense of capital formation. The stock market exists to facilitate capital formation, pooling investment capital for commitment to growth and value enterprises over time. The laws even require that capital formation be a priority. The Securities and Exchange Commission Act of 1933, incorporated into 15 USC 78, Section 2(b), says: Whenever pursuant to this title the Commission is engaged in rulemaking and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote … capital formation.
Those who contend theres no evidence structure is damaging capital formation arent tallying public companies. Through the history of the modern stock market in the United States, the trend line in traded issues has been steadily up as new enterprises outpaced consolidation. But since the order-handling rules took effect in 1997, which promoted price-and therefore arbitrage-to king of value in equities, the number of public companies has fallen precipitously. In 1998, there were nearly 8,000 issues in the Wilshire 5000, and today there are fewer than 3,600.
The equity markets volume reflects movement, not investment. Intermediaries dominate price-setting, clouding perceptions of what sets prices and whether supply and demand are balanced. The result isrelentless shrinkage in the product of capital formation: public companies.
Tim Quast is president and founder of equity market data-analytics firm Modern Networks IR in Denver.
