Regulators must stop the robots from ruining our stock exchanges, according to democrat Senator Ted Kaufman.
In a 5 August letter to SEC chairman Mary Shapiro, Kaufman warns that some algorithmic trading harms long term investors and dominates the equity markets in a way that brings no social utility. He describes some murky algo practices such as trading on advance information about other people’s orders, collecting unearned liquidity rebates and unnecessary intermediation, to support his case.
The Senator has picked up a useful ally in Gillian Tett, who used her FT column today to back his call for a review of high frequency trading. Tett explains his argument that the benefits of the narrow spreads which high frequency trading supposedly brings may be outweighed by hidden costs, leaving only a “thin crust” of liquidity that evaporates in bad times, as with the flash crash of 6 May.
In an separate but related story, the paper reports that two day-traders in Norway were indicted on charges of market manipulation after they stumbled across – and exploited - a trading pattern that tricked programme trading computers into raising their prices. Despite the breach of market rules, plenty of people cheered the duo for beating the machines: “Robots are designed to push the market but when someone pushes the robots it is suddenly a criminal offence,” was one comment on a Norwegian chat forum, according to the report.
Behind both these stories lies an unease about the growing dominance of robot trading. While not quite an android invasion, the increasing use of computers to arbitrage short-term price anomalies is a sinister development whose effects are not well understood. But it accounts for nearly 70% of US equity trading, making it an important source of revenue for stock exchanges.
As with all arbitrage, programe trading is useful up to a point. Price discovery, an appearance of liquidity and narrow spreads are seen as good for markets. But they shouldn't be confused with the equity market’s primary function of allocating capital to the most productive use. Common sense says that if the market were made up entirely of robots chasing price anomalies, it would not do its job very well.
Similarly, the experiences of the 6 May flash crash and before that the sub-prime sell-off, LTCM and Black Monday tell us that an appearance of liquidity from computerised trading is not the same as a truly deep market of buyers and sellers with different views.
The danger is that if robot trading ends up undermining investors’ confidence in the market, it will frustrate the market's core functions of providing a mechanism for collective investment in large undertakings (capital formation), and attracting long-term investors for that purpose. There is already evidence that equity investors are preferring bonds and commodities, with US equity mutual funds reporting net redemptions in July, for example.
Kaufman proposes a number of technical fixes, such as charging high frequency traders per message rather than per trade (some apparently send 100s or 1000s of buy and sell messages for every order filled, sometimes to "spoof" other algorithms), and a number of regulatory fixes including an emphasis on deeper, less fragmented markets. He doesn't mention the obvious solution of a transaction tax, but perhaps he's just being politic, since Geithner unfortunately rejected FTTs in the US last year.
Algo trading raises a similar concern as passive and active fund management, where some fear that the growth of low-cost index funds will smother the market's ability to pick winners and allocate capital effectively. Computer trading and passive funds direct huge quantities of dumb money without contributing much to asset allocation. But while the fund market can correct itself (active funds simply lower their prices and raise their game until they are competitive again), once robots have smothered the market like pondweed there's not a lot other investors can do to fight back.
We shouldn't forget that stock exchange executives need to make a profit too and keep their companies strong in a consolidating sector, hence their recent investments in HFT and dark pools. But to survive in the long-term, many years after Xavier Rolet steps down as CEO of the London Stock Exchange or Reto Francioni as head of Deutsche Bourse, exchanges need to deliver first and foremost for the equity market.
A quick look at Deutsche Boerse's website illustrates the problem. It lists its core values as integrity, transparency, precision, reliability, innovation and a focus on the needs of customers, investors and staff. These are fine values but it's strange that efficient capital formation is not among them.
It looks like we'll have to rely on regulators like Shapiro to save exchanges by making them perform their core economic function first, and make an honest profit - with or without robots - second. Like utilities, they are part of the infrastructure of finance. We readily accept that private water and energy companies serve us better when they compete within profit and capex limits set by public regulators. Why should stock exchanges be any different?
Update 23 August: This FT article reports that stocks are not responding as they ought to earnings news as macro-investing and programme trading have increased. Stocks in the S&P 500 are 60-70% correlated to each other today, up from 30% in the 1930s, making the ancient art of stock picking relatively pointless, at least until certainty returns to the market.