As the government mulls banking reform efforts officials hope will prevent a replay of the financial crisis of recent years, more than a few observers are worried about the growing threat created by those who trade stocks at lightning speed.
This so-called high-frequency trading engages in extremely fast buying and selling of stocks to generate profits. The few who do it account for significant amounts of volume for the word’s major stock exchanges, and as a result, are a potential source of system wide trouble.
A new paper published Wednesday by the Federal Reserve Bank of Chicago takes a look at the issue. While much of the piece, written by staffer Carol Clark, simply explains what high-frequency trading is, it also offers a few suggestions that could mitigate the risks of the strategy.
The threat is potentially real–some 70% of U.S. stock market’s total volume was driven by high-frequency trading, despite only 2% of trading firms engaging in the pursuit, according to research cited by the paper.
While this style of trading has an upside in creating liquidity in the stock market, critics worry that bad programming and human error could create catastrophic market moves. High-frequency trades are measured in nearly microscopic time intervals. Distance is also the enemy of these investors, who need to locate their operations next to major exchanges, because remoteness introduces enough too much of a lag into their activities.
The combination of blinding speed and machines is scary. “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,” Clark wrote.
Most of the marquee screw ups of the high-frequency trading world, as identified by the paper, deal with humans telling machines to do the wrong thing. While those errors have thus far been limited, they have on several occasions driven big market swings. Given that the financial crisis was defined by excessive borrowing that turned bad investments into huge bank-destroying losses, it’s natural to worry about strategies that can turn small mistakes into very big ones.
To prevent future snafus, the paper says a well-run high-frequency firm strategy must contain controls for order size and prices. Meanwhile, the system itself should be made more transparent. “Of paramount importance is the speed at which clearing members receive post-trade information from the clearinghouse and incorporate this information into their risk-management systems so that erroneous trades can be detected and stopped,” the paper said.
Clark warns, however, that when some entity places limits on high-frequency trading efforts, those firms could simply pick up and go where the rules are more friendly and less restrictive.
The Chicago Fed paper is primarily academic and deals with an area in which the Federal Reserve has little oversight, with stock exchanges overseen by other parts of the government.
That said, central bank officials have been arguing vociferously for the creation of some sort of entity that could ensure the stability of the financial system as a whole. This entity would be able to identify and remedy threats to stable market functioning. If high-frequency trading were to be seen as a potentially destabilizing force, this future regulator would likely act to rein in activity.