© James Angel
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The phrase "High-frequency trading" is a vague catchall term that has been applied to anyone using a fast computer. People use high speed computers for a wide variety of things, many of them beneficial to the markets but some of them harmful.
Critics believe that the lightning-fast trading strategies may be making financial markets less stable causing new types of serious risks because the speed and volume of trades distort prices. Meanwhile, others claim that HFT enhances market liquidity and reduces trading costs for all investors. To your mind, is HFT a threat to the financial markets or an important innovation that benefits investors?
Good uses of so-called HFT include traditional market making, which adds liquidity to the market and lowers transactions costs for other investors. In the US equity market, transactions costs for both retail and institutional investors have fallen in recent years. There is no evidence that HFT has made transactions costs go up.
HFTs also do arbitrage that keeps the prices of related assets in their proper alignment, which is another benefit to the markets.
However, some people use fast computers to engage in manipulative strategies, such as "order ignition." Therefore, we need regulators, who are smart enough to understand the difference between good and bad uses of high speed computers.
Overall market volatility is indicated by the VIX index fluctuates with macro-economic events. Intraday volatility (as estimated by the high-low estimator) is significantly lower now than it was in the pre-electronic early 1990s. This holds true for the median as well as the 95th and 99th percentiles. Thus, there is no evidence that HFT makes markets worse on average.
It is believed that HFT was the main cause of the stock market crash of May 6, 2010. Do you expect to see any regulatory reforms, which might forestall reoccurrence of crashes in the future?
I am concerned about the technical fragility of our markets. We have made a lot of progress since the Flash Crash, but there is still a lot of refinement needed to make sure that the inevitable technical problems are contained and do not do damage to the rest of the market.
In fact, the Flash Crash is widely misunderstood. There were actually three crashes:
1) A wave of sell orders caused the e-mini S&P 500 futures contract to crash and rapidly rebound. It is a matter of debate as to what caused the initial sell off. The U.S. Securities and Exchange Commission blamed a large sell order by a traditional money manager, not HFT, but this finding is not accepted by everyone.
2) Arbitrage activity transmitted the crash to the equity market leading to falls in the prices of the S&P 500 constituent stocks.
3) This resulted in a tsunami of message traffic that overwhelmed many trading systems and led to serious delays in various data feeds. This degradation of data integrity caused many market participants to activate their kill switches and withdraw from the market, which is the appropriate thing to do, when one suspects machine malfunctions. However, this caused many liquidity providers to withdraw from the market, leading to violent fluctuations in many non S&P 500 stocks, such as the infamous trade of Accenture at $0.01. The most affected stocks were the ETFs, whose values plummeted from the lack of market makers and arbitrageurs willing to step in amidst the scrambled data feeds.