Market Distortions, High Frequency Trading and Systemic Risk

London, UK - 2nd June 2010, 17:45 GMT

Dear ATCA Open & Philanthropia Friends

[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]

We are grateful to:

. Dr Harald Malmgren, Chief Executive, Malmgren Global, who has worked for four US Presidents in regard to World Trade and Investment Flows; and
. Mark Stys, Chief Investment Officer, Bluemont Capital Advisors, formerly the Head of Fixed Income and International Strategy at Fidelity Capital Markets;

now based in Washington, DC, and Virginia in the US for their response to our briefings:

. The Achilles Heel of Markets?
. Asymmetric Threat of a Second Great Depression? and
. Systemic Crisis: The Rise of Machines, Casinos and Illiquidity.

They write:

Dear DK and Friends

For decades, professional investment advisers have continued to teach reliance on “value investing” and “buy and hold” as long-term guides to successful investment. Chief economists and market pundits for financial institutions continue to urge us to keep focused on “market fundamentals” rather than sell when jostled by disruptive events, expecting “efficient markets” to generate a “fair price” in the whirlwind of market trading.

Your recent briefings that covered high frequency trading raised serious doubts about these traditional concepts of how markets work in the highly computerized, hyper trading world of today.

High Frequency Trading

Dark Pools and Flash Orders

High-Frequency (HF) traders thrive on a combination of asymmetric information advantages and extremely short-term profit objectives. Because of their high volume activity, HF traders have information on trades taking place in the “dark pools” of privately arranged transactions. They are also able to initiate almost limitless “flash orders” to ascertain the depth and breadth of the market, and identify if there are willing buyers at some level above most recent trades. Flash orders are small “immediate or cancel” orders, valid only for microseconds that carry little risk. By ferreting out buyer limits, HF traders have vastly greater knowledge of all aspects of the markets’ depth and breadth than individuals or passive investors like pension plans.

HF Modus Operandi

Computerized trading dominates today’s stock markets. Functioning within that world, HF trading casts a long shadow over value investing and market-determined prices. HF traders achieve profitability by skimming bid-ask spreads across a vast volume of transactions conducted in increments of millionths of a second throughout a trading day. Profitability does not depend on any assessment of the future value of any given security. The duration of holding a share is usually only a few seconds during which the bid-ask spread can be captured. HF traders position themselves as an intermediary between buyer and seller, extracting a small charge from every transaction with arguable benefit to either buyer or seller. The bid-ask spreads may sometimes be narrowed, but the primary determinants are the prices at which an HFT can gather and then distribute shares rapidly. Moreover, HF traders avoid carrying a position after market close, avoiding any exposure to the prospects of any business over night.

Skewing Market Prices

HF trading tends to be more profitable when markets are rising so that the bid-ask spread is maximized as HF traders fill any gap between buyers and sellers. When markets fall, there is a strong incentive to levitate markets back up to the levels prevailing before the sag, making profitable distribution of shares accumulated during the decline. On days of thin trading volume this can readily be achieved by well-timed surges of buys of ETFs such as SPY (S&P 500 ETF). Such surges can trigger automatic buy responses of the many algorithmic trading models on which other investors and traders rely. In sum, HF trading tends to operate with an upward market bias. While the differences may only be pennies per day, over time this upward bias likely lifts share price above the level that would otherwise materialize, potentially skewing true asset value.

Systemic Risk from Illusory Liquidity

HF trading tends to be less profitable during downturns, as the sale of purchased shares becomes more difficult in a falling price environment. Broker-dealers who are designated “market makers” are constrained by regulatory requirements that they must stay active and provide a bid when requested. In effect, HF traders also function as market makers but have no comparable obligations. If they sense an aberration in trading activity, particularly an abrupt downward movement in prices, they are free to withdraw from trading. In a rapid market decline, their absence is likely to amplify the rate of descent. When active, their voluminous transactions create an illusion of ample liquidity and balance between sellers and buyers. When they step away, this illusion is instantly dispelled. Thus, HF traders may often help moderate or smooth market volatility, but since they retain freedom of action to withdraw at their own discretion, they pose systemic risk.

Likelihood of Another Flash Crash

During the “flash crash” of May 6 a number of HF trading entities stepped away and liquidity disappeared. The May 6 flash crash only lasted a few minutes – but a future flash crash could well last much longer. In retrospect, it is highly doubtful that May 6 was the first time a number of HF traders stepped out. It would be irresponsible to view the May 6 flash crash as a onetime event with extremely low probability of recurrence.

Distortion of Market Correction

The process of HF trading gives the appearance of a huge, seemingly limitless array of buyers at any given moment, even on days of concern that markets might be overvalued or vulnerable to negative developments like the recent euro crisis. On such days, when traditional buyers absent themselves, negative market corrections may be avoided, delayed, or mitigated by the levitation of HF trading. The greater the time between true market corrections, the greater the distortion in price and the bigger the likely correction when HF levitation ends. Since major corrections invariably overshoot, the outcome will likely be uglier the longer the computer-driven postponement.


Essentially, HF trading functions as a positive feedback loop. Applied scientists and systems specialists treat positive feedback loops as inherently unstable. Each positive response generates stepped up repetition of the same actions. Positive feedback loops result in an ever expanding balloon, but like all balloons, risk of bursting increases with size. Some observers suggest that the risks of catastrophic market outcomes have become so great that regulators must ban HF trading. Trying to reverse technological progress has never been a very successful endeavour. Given the fundamentally different objectives of HF traders, their unlimited freedom of action, and their apparent dependence on positive feedback loops, regulators might be wise to devise compensating negative feedback mechanisms. Some commentators have suggested introduction of minimum holding periods for non broker-dealers. Alteration of incentives might be achieved by introduction of a sliding scale of fees or taxes according to volume and speed of trading. Or, if HF traders decide to withdraw they might not be allowed to resume trading for a specified period of days. That at least would reduce the evident risk of a market plunge resulting from arbitrary decisions to halt HF trading. The goal of regulators is not to get rid of HF trading but rather to realign its incentives to the objective of eliminating systemic risk.

All the best

Harald Malmgren and Mark Stys

Dr Harald Malmgren is Chief Executive of Malmgren Global and also currently the Chairman of the Cordell Hull Institute in Washington, DC, a private, not-for-profit "think tank". He is an internationally recognised expert on world trade and investment flows who has worked for four US Presidents. His extensive personal global network among governments, central banks, financial institutions, and corporations provides a highly informed basis for his assessments of global markets. At Yale University, he was a Scholar of the House and Research Assistant to Nobel Laureate Thomas Schelling. At Oxford University, he studied under Nobel Laureate Sir John Hicks, while earning a DPhil in Economics. After Oxford, he began his academic career in the Galen Stone Chair in Mathematical Economics at Cornell University. Dr Malmgren commenced his career in government service under President John F Kennedy, working with the Pentagon in revamping the Defense Department's military and procurement strategies. When President Lyndon B Johnson took office, Dr Malmgren was asked to join the newly organised office of the US Trade Representative in the President's staff, where he had broad negotiating responsibility as the first Assistant US Trade Representative. He has also served as principal adviser to the OECD Wise Men's Group on opening world markets, under the chairmanship of Jean Rey, and he served as a senior adviser to President Richard M Nixon on foreign economic policies. President Nixon then appointed him to be the principal Deputy US Trade Representative, with the rank of Ambassador. In this role he served Presidents Nixon and Ford as the American government's chief trade negotiator in dealing with all nations. In 1975 Dr Malmgren left government service, and was appointed Woodrow Wilson Fellow at the Smithsonian Institution. From the late 1970s he managed an international consulting business, providing advice to many corporations, banks, investment banks, and asset management institutions, as well as to Finance Ministers and Prime Ministers of many governments on financial markets, trade, and currencies. He has also been an adviser to subsequent US Presidents, as well as to a number of prominent American politicians of both parties.

Mark Stys is Chief Investment Officer of Bluemont Capital Advisers. He was formerly a senior bond trader with Fidelity Capital Markets, ultimately appointed Head of Fixed Income and International Strategy. He is a past member of the NASD Fixed Income Pricing Committee and frequent presenter for the NASD Town Hall meetings. A graduate of the United States Naval Academy, he was an aviator in the United States Marine Corps, and continues to function as Adviser to the United States Marine Corps' Strategic Initiatives Group.


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Best wishes

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