New research counters high-frequency trading’s bad rap
Nov 15, 2013 Bryan Borzykowski
High-frequency trading (HFT) systems have a bad reputation. Computers that rapidly buy and sell vast amounts of shares have been blamed for “flash crashes” like the one in 2010 that lopped 9% off the Dow Jones industrial average in five minutes and the 1% plunge in the S&P 500 last April in response to a Barack Obama assassination hoax.
Here in Canada prominent market players are starting up a new Toronto Stock Exchange competitor, called Aequitas, to control HFT activity. But as investors, regulators and politicians debate the pros and cons of automated trading, there’s a growing body of research that suggests high-frequency trading actually benefits retail investors.
Jeffery MacIntosh, a law professor at the University of Toronto and the author of a recent C. D. Howe report on HFTs, found that most computers act as market makers, middlemen that constantly buy and sell stock to keep markets liquid.
In the past, real people would do the buying and selling, and made money on the difference between buy and sell prices. HFTs make money this way too. But because they can buy and sell shares so quickly, they can generate profits off the slimmest price differences. Tighter spreads enable ordinary investors to buy stocks at lower prices, says MacIntosh.
HFTs also increase trading volumes, and that increases liquidity. That makes it easier and cheaper for people to buy and sell stock when they need to. “When they get into a market, the liquidity tends to increase quite dramatically, and that’s a benefit to all traders,” he says.
Computers have been criticized for quickly moving markets on news events, but Austin Gerig, a professor at Oxford University, says that also helps investors as it keeps global markets in sync. “You want prices to be updated as quickly as possible,” he explains. If they’re not, then investment firms could pass some losses on to their clientele.
At least some market players seem to agree with the academics. Vanguard Investments estimates that HFTs add about 1% a year to returns. While there will always be people who try to take advantage of investors, at this point the benefits of HFTs outweigh the negatives, says Gerig. “No one wants to go back to trading floors,” he says. “Who knows what will happen? But there seems to be a net benefit to this.’