The Current Danger of High Frequency Trading

Posted by Jeff Carter
on June 11th, 2012

One of the things that a market needs is lots of independent traders. Luis Zingales refers to that in his editorial piece in the Financial Times. “To function properly markets need a large number of independent traders.”

Right now, we are seeing a large contraction in the trading world. There are fewer and fewer independents. It is like watching the hardware industry revolution in the 1980′s. There were Mom and Pop hardware stores, some affiliated chains like True Value and Ace, and then Home Depot ($HD) launched. The aftermath of that revolution is a few more monstrous chains, Loews ($LOW), a smattering of surviving Ace and True Value hardware stores and very few Mom and Pops. At the low end of the food chain, the stores had to find a market niche they could exploit and service the heck out of their customers to survive. Otherwise, the commoditized hardware chains would blow them out of the water.

In trading, the algo shops are blowing independent traders out of the water. Banks, with government support, have become more dominant. But, there aren’t very many of them. They aren’t proliferating. One of the reasons is barriers to entry. On the trading floors of Chicago, we used to grow independent traders like the Corn Belt grew corn. There was always a consistent and ready crop available. It didn’t take a boatload of money to get started and if you failed, you failed rather quickly. The successful ones found their niche and exploited it. HFT trading is much more complex.

In order to become a HFT trader there is a high investment in systems, and algos. That takes engineering talent, which doesn’t come cheap. Then there are the capital requirements. Leasing a seat is a good idea for a newly committed HFT trader, your fees drop tremendously. HFT retail and you will be out of business because of commission.

What we are seeing today is a smaller and smaller pond. If things don’t change in a hurry, you are going to witness an HFT circle jerk. All the algo guys will try to pick each other’s pocket. That’s not an efficient marketplace.

The industry needs to re-imagine how computerization interacts with the marketplace. The structure of the market is totally busted on the SEC side. Internalization, dark pools, payment for order flow have buried any semblance of a fair and competitive market. Retail customers know that and it’s part of the reason money continues to fly out of the market place and into mattresses. That’s not a good development for capitalism.

On the CFTC side, certain markets have seemingly handled the transition well. The financial markets are the best example. However, the agriculture markets haven’t. While volumes are up, price discovery and transparency seem to be down. The futures market doesn’t resemble what is going on down on the farm, and volatility is extremely high contributing to fear. I was speaking with some grain traders the other day and there was a 9 point intraday move in some spread. That never used to happen.

In the hog market ($HE_F) which I actively traded, spreads and prices move wildly. Much more volatility than there used to be, and the Hogs were a volatile market!

The changes that have to be made are not about slowing the market down. But they might have to do with re-thinking co-location, re-imagining how humans and computers interact. Right now, we are still at 1.0 electronic markets. We need to get to 2.0, but it’s hard to move when it is so hard to innovate. Between start up expenses and government regulations, we have stagnated.

One thing is for sure. The longer we stagnate, the smaller the pool of players in the market becomes. That’s dangerous for free market capitalism.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.