September 2011

Confidence Lost: The Perilous Impact of High Frequency Trading

Author: Emily Johnson

Investment in American corporations through stock ownership has not only fueled the spectacular growth of the American economy, but has also formed the backbone of millions of Americans’ retirement savings. Through 401(k) plans, IRAs, and investment accounts, we have prudently diverted a portion of our paycheck toward investment for growth in equities, building nest eggs and preparing for our future financial needs and those of our families. The violent swings in the stock market that we have recently observed are threatening these nest eggs, and subsequently threatening the growth of the American economy. The so called “little guy” (which these days seems to mean any investor who is not a hedge fund, pension fund, or endowment) who has dutifully amassed a sizeable nest egg has been whipsawed by 600 plus point moves in the Dow Industrial Average not seen since the September 11 terrorist attacks. These unprecedented daily gyrations are frightening, and that fear is magnified for those who endured the financial crisis of 2008 (and who didn’t?). It is demoralizing, and it is stripping the confidence of the individual American investor. Sadly, this crisis of confidence is largely baseless, as these fear-inducing swings are caused less by economic news and corporate fundamentals (such as assets on a balance sheet or increased earnings, which are much stronger today than they were two years ago), and more by a sweeping, technology-based phenomenon called “high frequency trading.”

High Frequency Trading (“HFT”) is the use of computer-based formulas to trade large volumes of a security (usually stock or options) for the purpose of seizing opportunities in the market that last only milliseconds, essentially driving huge amounts of money into and out of the market at lightning speeds, creating vast swings in the price of one or more stocks and thus the overall market. Various resources estimate that HFT accounts for 60 to 73 percent of overall U.S. equity trading volume, yet represents less than 2 percent of trading firms. Remember the “flash crash” that occurred in May 2010? HFT, though not necessarily the instigator of this event, exacerbated the “crash” that ensued, driving the Dow down nearly 1,000 points before rebounding 600 points in the final minutes of trading, leaving both seasoned professionals and retail investors white-knuckled. How did a swing of this magnitude occur? Basically, computer-based formulas employed by HFT firms that control billions of dollars were triggered by the initial decline of one stock. And the formulas, not the humans who created them, drove the train from that point on.

Why is this important? Because these huge swings in the market are stripping the confidence of the average investor who dutifully diverts 5-10 percent of his or her paycheck into an investment account, 401(k), or college savings plan with the intent of investing in companies that drive our economy. Though proponents of HFT argue that this method of high volume trading brings liquidity and cost savings to the system by creating a more efficient market, results to date seem to indicate that HFT is undermining the integrity of the U.S. capital markets, which were created to enable individuals to invest in and fuel the growth of corporations that propel economic growth. And it is growth that our economy so direly needs. Markets are the epicenter of American capitalism, and they are under attack.

The SEC and other governing bodies have the ability to limit the activities of high frequency traders and thus bring sanity and confidence back to the market, but they remain inactive, apparently unable to determine the appropriate way to regulate these activities despite the many tools at their disposal. One such tool, called the “uptick rule,” was successfully used in 2008 to stem the run on bank stocks. Others are under discussion, though no action has been taken.

We hear copious amounts of commentary these days from politicians on the economy, unemployment, etc. Investment in corporations by the retail investor is essential to the health of our overall economy—corporations hire, they spend and invest capital, they develop new technologies and ideas. By allowing fear to permeate the markets and the mind of the retail investor, we are driving a nail into the coffin of our economy. Action needs to be taken to limit the activities of high frequency trading, to stem the unprecedented daily market gyrations, and to rebuild investors’ confidence in American capital markets.

Emily Johnson, CFP is managing director and founder of Polaris Capital Advisors, LLC, located on Hilton Head Island.

Let Us Know what You Think ...

commenting closed for this article