High Frequency Trading: The Best Of Technological And Financial Innovation... Or The Next Bubble?

from the where-are-things-headed dept

Over the last couple years there's been growing chatter about the rise of "high frequency trading," which is the increasingly sophisticated algorithmically-driven way of financial trading, where it has little to do with how smart your investment philosophy is, but how fast your hardware and algorithms run. As a principle, there's nothing wrong with the concept of high frequency trading. And, as many defenders of the concept point out, such systems, in theory, provide more liquidity to many markets, and basically skim pennies off the top in return for that liquidity. The potential problem, however comes in when such operations take over the market. The latest estimates put high frequency trading at 61% of the market -- up from 30% just five years ago.

That should be a warning sign. It's typical, but you can see it in plenty of previous Wall Street meltdowns as well. After someone figures out a "system" for making lots of money (say, mortgage-backed securities a few years back), everyone starts piling in. Then, the "innovation" occurs. Now, much of it is well-meaning, and even useful. With mortgage-backed securities, things like credit default swaps actually were a very useful insurance tool originally. But at some point, they basically flipped from insurance to gambling. People weren't using them to back up an investment, but as the investment itself -- so you'd actually have what was, in effect, thousands of people all buying an insurance policy that one house wouldn't burn down. If that house burned down... the insurance company (hi, AIG) defaulted, and everything comes crashing down. The problem is that these systems become so complicated that it's actually pretty difficult to figure out what the "trigger" is and how the disaster will spread. No one accurately predicted how the last Wall Street meltdown would occur (though some certainly predicted a meltdown), and the fear with the rise of high frequency trading is that the situation is even more opaque. What's happening is built into the algorithms, and with more and more companies piling in, it's inevitable that some of those algorithms are going to have a bug (or, not even a bug, but basically programming to do something that has serious unintended consequences).

Again, I doubt there's anything nefarious in most of this (unless you consider making money nefarious -- which I don't). But, at some point things get overwhelming, and many are beginning to wonder when we reach that point. I'm all for financial innovation and technology innovation -- but I have to admit to a bit of worry when the tech innovation seems to be taking over to such a level that there's little rationale for the financial side. It's about who has the better techies and hardware, rather than who has the better financial thesis, and that leads to dangerous results, because the purpose of the market is separated from the mechanisms that make the market run. When you get that kind of separation between form and purpose, bad things happen.

Filed Under: bubbles, efficiency, high frequency trading, liquidity