Monday, 7 December 2015

HFT, overtrading and casino capitalism

The extraordinary rise in financialization is the result of a growing economy and new trading and communication technologies. These reduced transaction costs putting speculation at the reach of a growing number of people, for increasingly short-lived and minuscule price discrepancies.

This can be illustrated by a permanent level of overtrading and the rising role of speculation in a casino-fashion, which may be exacerbated by the recent development of high frequency trading (HFT) at speeds only accessible to computers.

HFT refers to algorithmic trading which, according to some estimates, accounts for about 70% of all equity trading in the US stock exchanges. HFT has always existed whenever volatility and sentiment led investors to change quickly their positions. However, in the past the frequency of trading was limited by slow message networks and human communications (despite the development of gestural messages among traders).

With the development of electronic communications and trading platforms, human traders progressively reduced the time to move in and out of positions to a fraction of a second.

However, with the emergence of high speed computing and sophisticated decision and order transmission algorithms, now human traders can be replaced by computer traders which are not subject to such limits. Indeed, by connecting directly their computers to the exchange trading platform, some claim to be able to move in and out of a position in micro-seconds (one millionth of a second ) capturing a fraction of a cent in each trade and still make a profit.

For the time being the investment strategies more likely to be adopted by fast trading robots are front running and pump and dump (both illegal) as well as market making, ticker trading and various types of arbitrage. However, it is foreseeable that it will extend to all types of investment strategy.

The progressive substitution of human trading by robotic trading will certainly transform the equity market into a dual market of the kind already observed in currency markets, where the share of transactions for commercial (tourism, exports and imports) or investment motives (savings and portfolio allocation) becomes very small when compared to that of professional speculators. This evolution raises two types of concerns – excessive overtrading and casino-like price formation.

One must note that overtrading it is usually defined in two ways. In a business context the term is used to describe companies that are doing more business that their working capital can sustain. In the context of markets the term is usually used to describe the brokers practices to influence their customers to engage in excessive buying and selling. I will retain here a broader definition based on financial cycles due to rising volatility and increased speculation.

The drivers of financial cycles would not be fundamentally different from those driving business cycles if it was not for the fact that trading in financial assets seems to go on rising unabated despite recurrent crisis and significant consolidation. For instance, the recent substitution of 18 currencies by the Euro did not result in any reduction in forex trading, quite the opposite. Between 1998 and 2013, the daily average volume of trading rose from US$1.5 trillion to US$5.3 trillion, an amount equivalent to 17.5 times the value of the daily production in the world.

This is only possible because the market is dominated by a dozen of large banks (or market makers) engaged in what one may consider a never ending zero-sum game through which they can only grow by taking ever larger bets against each other. The continuity of this game has an obvious benefit by creating a huge liquidity pool, so that those trading for commercial or investment reasons no longer are limited by the size of the market.

However, this benefit may have serious costs in terms of new operational risks and loss of the information provided by prices. Operational risks occur in the form of flash crashes of the kind occurred in New York on May 6, 2010 and in Singapore on April 23, 2013. Nevertheless, despite the individual havoc that these may cause, they may be considered as “teething problems” which will be minimized to avoid its frequent recurrence and the contamination of the real sector of the economy.

On the contrary, the transformation of markets into casino-like gambling has two enduring risks – boosting financial crisis and diluting the importance of markets for the efficient allocation of resources.

In itself, HFT has not been at the origin of financial crisis, and it is still too early to know if it plays any role in their amplitude.

Since price signaling is a key foundation of market capitalism, there has been a heatedly debate on whether speculation improves markets. In theory, its stabilizing role seems to win the argument, at least in currency markets. In these markets the fundamentals still play a role in the long term, because in currency markets some players (central banks) are legally entitled to collude to manipulate the markets into stabilization. However, in equity markets only trading halting rules perform such function because there is no entity with a stabilizing role.

So, whenever the level of overtrading in equity markets reaches currency proportions we do not know if monetary authorities are able or willing to step in to stabilize equity markets in a similar way. What we know from the latest bubbles is that central bankers alerts about “irrational exuberance” may be ignored for several years. For instance, during the internet bubble of the 1990s it took four years from 1996 to 2000 before the bubble burst by itself.

Overall, neither HFT nor overtrading risks represent a global catastrophic threat to capitalism similar to that of a nuclear arms race or experiments with high-energy super colliders.

Nevertheless, we need to know more about their distortionary impact on price formation and the allocation of leverage to competing projects. Otherwise, to put it in Keynes words (1936): “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done”.

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