Financial markets are like time machines. The buyer of an equity turns today's lump sum into tomorrow's stream of dividends; the seller turns future income into cash to be spent now. Yet even as financial markets ease time's tyranny, critics rail that they are rigidly short-termist. The latest target of this misconceived abuse is high-frequency trading.
Until recently, few paid attention to this abstruse corner of finance. But in January the Securities and Exchange Commission announced it would be studying high-frequency traders and, in the wake of May's “flash crash”, politicians and regulators pointed the finger at the high-frequency crowd. The crash post-mortems have yet to show a link to rapid traders, but the critics are not bashful. After all, shadowy computer geeks have built systems whose split-second trades account for more than half the turnover on US equity markets. Here, surely, is a devil's cocktail of cut-throat finance and black-box technology – an unholy fusion of Gordon Gekko and 2001: A Space Odyssey.
Wait a minute. Financial markets, like grocery markets, need participants who specialise in the short run. Denouncing high-frequency traders for their quick turnover of inventory is like grumbling that your local shop only holds soap powder for the short term. Financial short-termists are often called “marketmakers” because without them markets would not function. Pension and insurance funds and other long-termists count on being able to buy and sell stocks easily. They pay a premium for this liquidity, and this cuts the cost of capital to public companies. Thus do marketmakers boost investment.
If marketmakers are necessary, what sort should we favour? The traditional “specialists” collected buy and sell orders; if they thought the clearing price for a stock was $10, they might offer to buy it for $9.75 or sell it for $10.25. Because $10 was a mental (and sometimes Martini-coloured) estimate, the specialists needed a fat margin of error. But today's computerised marketmakers can track the order flow far more precisely, so can afford to make quotes pennies off the clearing price. So, bid-ask spreads in US stocks have fallen steadily since the 1980s and by about a third in four years. Savers have benefited, to the tune of billions of dollars.
It gets better. In the past five years, daily volume on the New York Stock Exchange has shot up from 2bn to 5bn shares, mostly because of high- frequency traders. The greater volume means that large institutional investors can move big blocks of equities without pushing prices against themselves. In one of the first academic studies of high-frequency trading, Jonathan Brogaard of Northwestern University concludes that if high-frequency traders withdrew from the market, the average trade of 1,000 shares would move the market by an additional 5.6 cents. The Vanguard Group, a large mutual fund company, estimates the effect of deeper markets and narrower spreads has halved trading costs in the past decade.
Even if high-frequency traders make markets more efficient, the critics still do not like them. (Then again, to extend the grocery analogy, they don't like Walmart either.) The SEC appears concerned that, unlike the regulated specialists, high-frequency marketmakers are under no obligation to quote prices through all market conditions; their on-off participation might exacerbate volatility. But Mr Brogaard's statistical tests find no evidence for this worry. The truth is computers are more likely than specialists to keep their nerve in turbulent markets, for the good reason they don't have nerves.
The SEC seems to be considering a minimum quote time. Rather than allow such traders to extend and withdraw quotes in milliseconds, it might prefer them to stand by their offers for, say, a second. But the longer the quote period, the higher the risk the price may move against the marketmaker – and the wider the spread will have to be to compensate.
No doubt one day high-frequency traders will be found guilty of something. There are rumours they deliberately slow down exchanges by “stuffing” them with orders. That should be stopped if it is happening. But until such an allegation is substantiated, robo-traders must be deemed innocent. May they clone themselves a thousand times.
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