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Cracks in the Pipeline 2 MEDIA CONTACT: Lauren Strayer | [email protected] 212-389-1413 FINANCIAL PIPELINE .o rg Series CRACKS IN THE PIPELINE 2 HIGH FREQUENCY TRADING by: Wallace C. Turbeville his is the second of a series of articles, that increase the inefficiency of Capital Intermediation and entitled “The Financial Pipeline Series”, its cost. The increased volumes in the traded markets are examining the underlying validity of the largely a result of high-speed, computer driven trading assertion that regulation of the financial by large banks and smaller specialized firms. This article markets reduces their efficiency. These illustrates how this type of trading (along with other activ- articles assert that the value of the finan- ities discussed in subsequent articles) extracts value from cial markets is often mis-measured. The the Capital Intermediation process rendering it less efficient. efficiency of the market in intermediat- It also describes how the value extracted is a driver of even ing flows between capital investors and more increased volume creating a dangerous and powerful capital users (like manufacturing and service businesses, feedback loop. individuals and governments) is the proper measure. Unreg- Tying increased trading volume to inefficiencies runs ulated markets are found to be chronically inefficient using counter to a fundamental tenet of industry opponents to Tthis standard. This costs the economy enormous amounts financial reform. They assert that burdens on trading will each year. In addition, the inefficiencies create stresses to the reduce volumes and thereby impair the efficient functioning system that make systemic crises inevitable. Only prudent of the markets. regulation that moderates trading behavior can reduce these The industry’s position that increased volume reduces inefficiencies. transaction cost is superficial, if not negligently or inten- tionally erroneous. Its position is based on a simplistic INTRODUCTION syllogism: all trading volume increases market liquidity, The prior article in this series points out that the most market liquidity reduces transaction costs and reduced important social purpose of the financial markets is to trading costs benefit the economy. But there are critically facilitate the movement of funds from (a) holders that seek important distinctions between trading volume and levels investment opportunities to (b) businesses and governments of market liquidity; and trading activity that increases the who need to put investment capital to work in produc- cost of Capital Intermediation, even though it may reduce tive ways and to individuals who seek to borrow for their transaction costs, does not necessarily benefit the economy current needs. This function is referred to in this series as on a net basis. “Capital Intermediation.” The article describes findings that This article will explore the concepts of volume and the cost of Capital Intermediation has increased significant- market liquidity, including critical distinctions between ly over the 35 years of financial market deregulation in the them. Liquidity benefits market participants. A market United States, despite advances in information technology is considered liquid to the extent that there are levels of and quantitative analysis that intuitively should have in- buying and selling interest sufficient so that one who wishes creased efficiencies in the process. Instead, Capital Interme- to transact can be assured that he or she can complete the diation has become less efficient. transaction close to the price most recently quoted on the Academics speculate that this increased cost must have market. Another way to think about liquidity is that it pro- something to do with the massive increase in trading in the vides stability of prices within the current spread between securities and commodities markets over this period. This reliable purchase and sale price quotes. Predictability and is correct, but incomplete. Volume, per se, has not caused stability are closely related. Capital Intermediation to become more inefficient. Rather, Deregulation and technology advances have greatly particular types of trading that generate tremendous vol- increased trading volume. However, this article will show umes have caused it. Thus, observed high trading volume that much of today’s historically high trading volume does includes - actually is dominated by - specific types of trading not provide market liquidity when markets are under stress 1 • Cracks in the Pipeline | February 2013 - that is to say at precisely the time that liquidity is most FIGURE 1. TRADING VOLUME: U.S. EQUITIES needed. On the contrary, this large category of trading vol- 500% ume reverses itself and consumes market liquidity in great 450% quantities at these times. The shift from providing liquidity 400% to consuming it is unpredictable and, as a result, even more 350% disruptive. And these shifts occur on a daily basis. 300% Furthermore, a substantial portion of this volume is 250% specifically designed to subvert the essential price discovery 200% function of the marketplace. Price discovery allows market 150% participants to observe market prices levels at a given point 100% in time. In a well-functioning market, price levels reflect the 50% fundamental value of securities and derivatives being traded 0% based on currently available information that is relevant to 2011 1988 1989 1990 1991 1992 1993 1995 1996 1997 1998 1999 2000 2001 2002 2003 2005 2006 2007 2008 2009 2010 fundamental value.1 Even when the market is not stressed, 1994 2004 commonly used high volume trading tactics drive market Source: World Bank, available at http://data.worldbank.org/indicator/CM.MKT. prices away from the fundamentally sound values that effi- TRAD.GD.ZS/countries/1W?page=4&display=default cient markets achieve. As a result, the price levels discovered FIGURE 2. INITIAL PUBLIC OFFERING OF EQUITY SHARES by market participants are distorted by market maneuvers IN 1980 2000, AN A VERAGE OF 311 FIRMS WENT PUBLIC EVERY YEA R and are unreflective of fundamental values, reducing market IN 2001 2011, AN A V ERAGE OF 99 FIRMS WENT PUBLIC EVERY YEAR efficiency. 800 80 Finally, in order to avoid these tactics, many market NUMBER OF OFFERINGS AVERAGE FIRSTDAY RETURNS participants have opted for “Dark Pools” and trading that 700 70 is internalized to broker/dealers. In each of these trading 600 60 venues, price quotes and orders are hidden from the general market. These are alternatives to “Lit Venues,” i.e., exchanges 500 50 and transparent trade matching venues in which quotes are 400 40 disclosed. This reduces price transparency overall. Notwith- 300 30 standing some analytical work that has been interpreted to NUMBER OF OFFERINGS AVERAGE FIRSTDAY RETURNS the contrary, the migration of trading price data to Dark 200 20 Pools and internalization programs damages essential price 100 10 discovery. O O Chronic price distortions are not merely vehicles for clever traders to get the better of slower and weaker market 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 participants. Distortions caused by illusory liquidity, aggres- Source: Ritter, J., “The Death of the IPO Market for Small Companies,” June 2012, sive trading tactics and non-transparent trading make the available at http://www.mfsociety.org/modules/modConferences/uploadFiles/misc- marketplace unreliable. There is ample evidence that major Files/1338976045-Plenary_Talk_Pres_Slides_Jay_Ritter.pdf securities and derivatives markets in the US are widely It is abundantly clear that equities trading volume viewed as unreliable. In response, investors adjust the prices growth is a function of algorithmic and high frequency required to induce them to deploy their funds so as to pro- trading (“HFT”). This technique, developed over the last vide a buffer against unreliability. This is a drag on produc- two decades, is employed widely in the markets. It is char- tive investment in businesses, governments and households. acterized by fully automated trading strategies intended to It is also a direct transfer of value from the productive users profit from market liquidity imbalances or other short-term of capital (and ultimately the American public) to the finan- pricing inefficiencies.2 It has been estimated that today 73% cial institutions that exploit (and quite often create prior to of equity trading volume is a result of algorithmic and high exploiting) these price distortions. frequency trading.3 HFT has changed fundamental char- acteristics of markets. It has been estimated that at the end TRADING VOLUME IN THE ERA OF DEREGULATION of the Second World War, the average holding period for Across all markets, trading activity has increased enor- stocks was 4 years. By the turn of the millennium, it was 8 mously during the time of deregulation. Equities markets months. By 2008, the average holding period declined to 2 are the deepest and most liquid securities markets. Trading months. And it has been estimated that, at least for active- in the US equities markets has reached extraordinary levels. ly traded shares, it had declined to 22 seconds by 2011.4 (See Figure 1) Obviously, trading that churns the market has increased This has not been because of new issues of shares that tremendously. would have increased the amount of equities available to While there has been speculation that high frequency trade. The supply of new issue equities has been relatively trading may have declined recently, a November 2012 study low for years. (See Figure 2) funded by the Commodity Futures Trading Commission focusing on the equities futures market, an integral element 2 • Cracks in the Pipeline 2 | February 2013 of the equities market, finds that the percentage share of sellers when his or her posted offer to sell is matched with a HFT in that sector has remained constant.5 buyer. As we shall see, this is exceedingly simplistic. Bond market trading has increased as well. From 1996 Bid/ask spreads are related to market liquidity.
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