October 26, 2023
The question must be asked: What takes priority? The use of technology to increase transaction speed or the need for efficient markets to deliver the information that investors require.
In recent years, the financial world has witnessed a seismic shift as automated trading has evolved into algorithmic trading and high-frequency trading (HFT), whose strategies now prevail over trading in markets by independent investors whose trading decisions are based on the underlying value of a corporation’s operations and finances and the discount or premium to market prices.
These automated systems, characterized by their lightning-speed execution of pre-programmed trading instructions, have undoubtedly revolutionized market transactions. However, as algorithmic and HFT trading strategies have become more pervasive, concerns about their potential impact on market and corporate stability have grown substantially.
This article explores the unintended consequences of pursuing trading speed versus investment efficiency, shedding light on the ongoing debate surrounding market integrity and equity markets’ role in the automation age.
The Emergence of Algorithmic Trading
Algorithmic trading has unlocked unprecedented speed in market transactions. High-frequency trading (HFT), a subset of algorithmic trading, takes this concept to the extreme. HFT firms employ cutting-edge technology, often unfairly co-located with exchange servers, to gain an edge by executing thousands of trades within microseconds. Their actions are primarily driven by immediate data analysis and predefined algorithms, trading against reacting human emotion, making prudent human decisions and actions obsolete, which is a ridiculous concept.
While automated trading has undoubtedly delivered numerous benefits, its extension into algorithmic trading and HFT has also given rise to serious concerns, including:
- Liquidity Drain: Despite the promise of increased liquidity, HFT strategies, in a flash, also withdraw funds from the market during times of stress, amplifying liquidity crises.
- Market Volatility: High-frequency trading strategies can exacerbate market volatility. Rapidly executing a large volume of trades via exchange-traded funds leads to sudden and significant price fluctuations and market imbalances, causing abrupt disruptions and unforeseen cascading effects. Investors are left bewildered while traders seize the advantage.
- Investor Confidence: Independent investors are questioning equity market fairness. The speed and precision of co-located server-based algorithmic trading raise concerns about market integrity and the inherent advantages sophisticated trading firms enjoy.
- Transparency: Critics argue that the intricate nature of algorithmic trading makes it challenging to detect manipulative practices or unfair strategies, raising questions about market fairness.
- Overreliance on Technology: The dependence on automated trading systems exposes the market to the risk of system glitches, malfunctions, or cyberattacks, potentially threatening market stability.
Safeguarding Market Integrity
Addressing these concerns is imperative to ensure investor confidence and market stability. Various steps could be taken to mitigate the potential adverse impacts of algorithmic trading:
- Regulatory Measures: Regulatory bodies must adapt to this evolving landscape by eliminating co-located HFT and exchange servers and implementing stricter trading rules to ensure transparency, monitor trading practices, and limit excessive trading and investing risks caused by algorithmic traders.
- Market Circuit Breakers: Additional market-wide and single-stock and ETF circuit breakers could help prevent extreme price swings by temporarily halting trading during times of distress.
- Real-time Monitoring: Advanced surveillance tools could identify unusual trading patterns and potential manipulative activities, enabling immediate intervention.
- Enhanced Risk Controls: Trading firms, especially HFT firms and exchanges, could be required to implement more robust risk controls to minimize the impact of technology failures.
- Investor Education: Independent investors should educate themselves about the impact of algorithmic and HFT trading and consider adapting long-term strategies to navigate this new landscape. This is why I wrote The Maverick Investor’s Handbook and started a related program.
Algorithmic trading, including HFT, has revolutionized the financial markets, offering unprecedented speed far beyond independent investors’ capacity to cope. However, the unintended consequences of these automated trading strategies have raised concerns about market stability and integrity. As the financial landscape evolves, regulators and market participants must collaborate to maintain a secure and transparent trading environment for investors. Investment is the underlying reason for stock exchanges, not quick-draw trading. Striking a balance between the benefits of algorithmic and HFT trading and the imperative of maintaining market fairness remains a critical objective to safeguard the global financial system’s integrity and preserve investor confidence in equity markets.
Pursuing responsible and ethical trading practices is paramount in a rapidly changing landscape. I urge international securities regulators to resolve this problem before the global financial system collapses, which will be worse than in 2007-2008.