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Equity markets are more volatile than ever, and many observers say high-frequency trading is the reason.
Vincent Ryan, CFO Magazine
November 1, 2011
Although CFOs are not supposed to have their eyes fixed on their company's stock price, it was hard to look away from the train wreck of May 6, 2010. A sudden intraday drop in securities prices caused the Dow Jones Industrial Average to fall nearly 1,000 points within minutes. The prices of some stocks were massacred, falling to as low as a penny a share.
If the "flash crash" wasn't proof enough that the extremes of volatility in the equity markets have worsened, more evidence accrued this summer: in August stock prices fluctuated wildly for four days in reaction to Congress's handling of the federal debt ceiling and Standard & Poor's downgrade of the United States's credit rating.
The equity markets have become a lot more volatile on relatively normal days, too. The so-called fear gauge — the Chicago Board Options Exchange's Volatility Index (VIX) — has averaged 22.3 this year, compared with 15.5 in 2004, the year the method for calculating the VIX was changed. From 2008 to 2010, during the peak of the Great Recession, the VIX averaged 32.7, 32.1, and 28.9. This fall, the VIX spent a lot of time above 40.
What's behind the new volatility? While economic uncertainty and global debt crises cause large dips and jumps in indexes, regulators and institutional investors say high-frequency trading (HFT) is the culprit.
HFT firms use superfast computers and networks to jump in and out of stocks, capitalize on other investors' moves, and, sometimes, illegally manipulate markets. They use algorithms instead of human intervention to decide when and where to invest. And HFT firms often locate their computer networks close to a trading network's servers, so they can "see order flow milliseconds faster than most normalized trading desks," says Ryan Larson, head of equity trading at RBC Global Asset Management. That allows them to jump in front of other investors' buy and sell orders, which can exacerbate the overall markets' ups and downs.
High-frequency trading is now estimated to account for more than 50% of trading volume in the equity markets. HFT firms have, in effect, replaced banks and other traders that used to make a market in stocks.
HFT traders have also driven out traditional "prop" firms that trade with their own money and are not highly automated. That has caused trouble in rocky markets. "When the market starts to get rough, sometimes you need some rational thought," says Dennis Dick, a trader and market-structure consultant at Bright Trading, a broker-dealer. "During the flash crash, when some stocks fell to a penny a share, the computers were 'hitting the bid' [that is, selling] thinking that was the best price, not realizing that it wasn't rational for a stock like Procter & Gamble to be trading at a penny."
They "Completely Walked Away"
Why should issuers care about volatility? For starters, volatility curbs institutional and individual investors' enthusiasm for equities, leaving a good portion of the market's trading to short-term investors who act on market momentum and algorithms rather than an issuer's earnings and business prospects. Additionally, a yo-yoing stock price doesn't help a company when it's trying to raise additional capital or pinpoint when to buy back stock.
A high VIX also keeps private companies from listing: the index has to be around 15 for the market to be stable enough to price an initial public offering. Only 18 U.S. companies listed in the third quarter of 2011, a 33% decrease from a year earlier. It was the slowest quarter for IPOs in two years, according to Renaissance Capital.
Inside a company, the perception of disorderly markets affects employees, says Dick. "If you have a lot of employees with a lot of stock options and stock ownership, it doesn't help employee morale when your stock price isn't stable."
During periods of stability, HFT firms do help create market liquidity and narrow the bid-ask spread, allowing an investor to obtain its target price for a stock. But in downward, panicky markets, HFT traders may just contribute to the chaos. According to the official U.S. government investigation of the flash crash, HFT firms absorbed some initial selling pressure, but then "saw the order flow coming and completely walked away," says Larson.
"Once you add a market-impact event, like a terrorist attack or a credit crisis, the high-frequency traders hit the 'off' switch, and all of a sudden there is no liquidity," observes Dick.
High-frequency traders claim they are an easy target of investors who have failed to adapt to the new trading technologies. "Anyone who thinks they are going to slow down [trading] is trying to defy the natural proclivity of technology and people," said William J. Brodsky, chairman and CEO of Chicago Board Options Exchange, at a Baruch College conference.
"I think the whole idea of electronic-trading firms exacerbating volatility just hasn't borne out to be true," says Adam Nunes, a business-development executive at Hudson River Trading, an algorithmic-trading firm.
Indeed, firms that engage in HFT can't all be painted with the same brush. Arbitrage-type firms capture price inefficiencies between related products or markets, or trade based on statistical relationships between instruments. For example, a trader may exploit the link between an airline stock and an exchange-traded fund based on the price of oil, says Ciamac Moallemi, an associate professor of decision models and security pricing at Columbia Business School. "If the oil ETF is jumping up, and the airline stock isn't going down, they will short the stock," Moallemi says. Such a strategy is largely seen as benign.
But there are two other HFT strategies that market participants claim are predatory: "order anticipation" and "momentum ignition." In these instances, HFT firms use their direct market access to monitor order flow marketwide and trade ahead of large investors.
In momentum ignition (perhaps the most egregious example), an HFT firm places a series of orders or trades to create a rapid increase or decrease in prices. It does so by "triggering other traders' algorithms into buying or selling more aggressively, or by triggering standing stop-loss orders — an order to sell when the price of a security dips to a certain level — to cause a price decline," according to a securities alert issued last year by law firm WilmerHale. "The [HFT firm] profits by liquidating an earlier established position." High-frequency traders that design a system to take advantage of another trader's algorithm are predatory, says Andre Owens, an attorney in the securities practice at WilmerHale. "That's what the Securities and Exchange Commission should be cracking down on."
Yet another strategy that regulators say HFT firms practice is "quote stuffing" — sending out huge numbers of orders to buy and sell stocks to see where the real buyers and sellers are in the market, then canceling those orders. The HFT firm uses the information obtained to trade against those investors.
These HFT strategies cause institutional and individual investors to pay higher prices when they are trying to buy, and receive lower prices when they are trying to sell. "By the time the investor executes a trade, the stock has moved several pennies," Larson says. For an investor trading large blocks of shares, that gets expensive. And it's also why markets are more volatile. "In up markets, stocks are pushed higher [by the HFT firms' strategies], and in down markets the bid — the price at which investors will buy — keeps 'falling out of bed,'" says Larson.
High-frequency trading not only raises the issue of fairness — whether or not the equity markets are a level playing field — it also poses systemic risk in choppy markets.
HFT firms are under no obligation to step in and "be the buyer of last resort" of a stock, as traditional market makers were. "They have all the benefits of the traditional market maker, but they don't have oversight obligations, don't have to report to the SEC, have no capital requirements, and don't have to make continuous markets," says James C. Allen, head of capital-market policy at the CFA Institute, an association of investment advisers. A chorus of investors is calling on the SEC to impose some of these obligations on HFT firms.
Meanwhile, although the SEC has proposed other rules to address the causes of the flash crash (see "Tracking Traders" at the end of this story), its slow pace has disappointed investors and traditional traders.
The regulator is asking the right questions, says WilmerHale's Owens, but "matters related to the Dodd-Frank Act are taking up a lot of attention at the staff level. Still, there is a core group of folks in trading and markets, and at some point I would expect [some new rules] about equity markets to come out."
"A lot of these proposals are, unfortunately, still proposals," says Larson of RBC. "While some things have been accomplished following the events of May 6, 2010, very few enforcement actions have been taken."
The SEC faces more than just thin staffing. As noted by an adviser in the SEC's division of trading and markets at an industry conference last September, the commission just doesn't have the technology yet to identify and police high-frequency traders. But even if it does get sophisticated systems to track suspicious market activity in real time, "it will [still] take [the SEC] a long time to figure out what to do with that information," Larson says.
Meanwhile, the possibility of other market crack-ups looms.
Vincent Ryan is senior editor for capital markets at CFO.
The SEC proposes new rules to monitor equity trading and limit wild market swings.
The Securities and Exchange Commission has a lot more work to do to address equity-market volatility and high-frequency trading, but there are some rules in the proposal stage:
Consolidated audit trail. U.S. regulators had huge problems deconstructing the "flash crash" — finding out which traders contributed to the volatility, what actions they took, and what ultimately caused share prices to fall so precipitously. This rule would require stock exchanges to develop an audit system to track trade orders and execution. Although the SEC proposed the rule on May 26, 2010, "we're still miles away from a consolidated audit trail," says Ryan Larson, head of equity trading at RBC Global Asset Management.
Large trader rule. Adopted this past summer, this rule requires large traders — those that trade more than 2 million shares or $20 million a day being one threshold — to report to the SEC and be assigned a unique identification number. Broker-dealers that interact with these large traders would use that identifier to keep transaction records. They would have to supply the records to the SEC upon request. Buy-side traders have until December 1 to comply.
Limit up–limit down. This rule would replace existing individual stock circuit breakers. It would restrict trading in a stock whose price is moving in a volatile manner. For example, a 15-second time limit might be set during which trading a certain stock outside a 5% or 10% price band is prohibited. If liquidity for the stock didn't improve, trading in the stock could be halted for five minutes.
Marketwide circuit breaker. Replacing circuit breakers imposed in October 1988 that were designed to avert large sell-offs, this new circuit breaker would lower the size of the market drop that would trigger a circuit breaker. It would also shorten the duration of trading halts and switch the index by which a market decline is gauged to the S&P 500, from the Dow Jones Industrial Average. — V.R.