No to a higher frequency flash crash
Comment of the Day

August 22 2011

Commentary by David Fuller

No to a higher frequency flash crash

This is a good column (may require subscription registration, PDF also provided) by John Plender of the Financial Times on a subject often mentioned by Fullermoney. Here is the opening:
The good news about the extreme market volatility of the past month is that there has been no repeat so far of last year's notorious Flash Crash, in which $1,000bn was wiped off share values in half an hour. Yet that is no reason to be complacent about the activities of high frequency traders who are engaged in a high-tech arms race to reduce trade execution times to millionths of a second.

For conventional investors there is a long-standing concern about the uneven playing field on which they compete with traders who can afford to co-locate their high-tech kit expensively beside exchanges to reap a time advantage. While it is true that the bigger fry have always had a natural advantage in capital markets against the small, it is a legitimate goal of regulation to try to level the playing field as far as possible. And it would be good to have a regulatory verdict on whether predatory algorithmic traders are artificially manipulating prices at the expense of slower or less sophisticated market participants.

I am also profoundly suspicious of the practice of "pinging", whereby traders send out and cancel a multiplicity of orders until they manage to identify hidden pools of liquidity from which they can extract a predatory profit. The orders entered by such traders are now a huge multiple - even hundreds of thousands - of the trades actually effected.

Small wonder Lord Myners, the UK's former City minister, expressed concern last week that high frequency trading was so remote from the true function of the capital markets. It is high time we had a definitive verdict from the securities watchdogs on whether the unholy alliance between these traders and the managers of exchanges and trading platforms acts as a stealth tax on ordinary institutional and retail investors. For the formal exchanges in particular, which have seen their market share collapse as a result of liberalisation and the arrival of new trading platforms such as dark pools, the increased volumes generated by high frequency trading have been a boon. Note, in passing, that the New York Stock Exchange's share of the trade in NYSE-listed securities fell from 80 per cent in 2005 to just 24 per cent in early 2011.

David Fuller's view I have written about high-frequency trading on a number of occasions. It can only end badly for all the reasons previously mentioned, a number of which are also summarised by John Plender.

Those most at risk are leveraged traders and anyone else who is liable to be frightened away by periodic spikes in volatility. However, investors can also profit from the volatility if they have some GTC buy orders at lower levels.

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