Satyajit Das: When the machines are insider traders, will they be prosecuted?
Das Capital: Making mountains out of molehills sells more books than a study of molehills
Satyajit Das writes the Das Capital Column in the Independent. He has worked in financial markets for over 35 years, as a banker, a corporate treasurer and now as a consultant to banks, fund managers, governments, companies and regulators around the world. He is also the author of Traders Guns and Money and Extreme Money as well as a number of reference books on derivatives and risk-management, which double as 'door stops'. He became a banker because he wasn't good enough to be a professional cricketer, but would give up finance if anyone offered him a job as a cricket commentator or allowed him to pursue his other passion- wildlife (he is the co-author with Jade Novakovic of In Search of The Pangolin: The Accidental Eco-Tourist). He lives in Sydney, Australia.
Friday 27 June 2014
High-frequency traders are back in the spotlight, thanks to the New York Attorney General's lawsuit this week over Barclays' "dark pool" market and Flash Boys, the latest book from the celebrity finance writer Michael Lewis.
Mr Lewis's recent claims that "the US stock market is rigged" provided his book on high-frequency trading (HFT) with the oxygen of controversy and prime-time publicity. But Flash Boys is a missed opportunity. With the trading of stocks and other financial assets increasingly being driven by computerised algorithms, it diverts attention from important issues – the role of information and market-makers, trading volumes and the basic system of markets.
All markets require liquidity providers to facilitate normal commercial purchases and sales. Historically, designated market-makers supplied liquidity by assuming the risk of taking on positions as required. In some market structures, there was also a separation between these market-makers and pure brokers who acted on behalf of clients wishing to buy or sell.
Buyers and sellers want a transparent process. They want timely access to trading prices and volumes, allowing them to be informed about the correct market price of securities in making trading decisions.
Fair, transparent market structures that meet these criteria and do not favour insiders or benefit any group are one of the holy grails of capitalism. But they conflict with the desire of all market participants to gain a competitive advantage – for example, through superior access to information or faster execution of orders than rivals.
Modern market structures including HFT are merely a 21st-century incarnation of these basic tensions. While they are more hi-tech, it is doubtful that they are any better or worse than their antecedents. In essence, all markets are "rigged", with only the degree and precise mechanisms being different.
Opponents argue that some HFT trading strategies are designed to manipulate the market. Signals are sent to elicit information about other traders' positions or camouflage trading intent. Humans have been doing that for a very long time.
Defenders of HFT and modern market structures argue that the complex current arrangements have benefited investors by increasing liquidity and lowering transaction costs, usually measured by the spread between buying and selling prices. This is predicated on the need for increased trading volumes.
But high volumes are not necessarily beneficial. Investors only need liquidity to increase or decrease portfolio holdings in response to cash inflows or outflows as well as new information affecting values. There is limited support for the idea that higher trading volumes improve market efficiency –which is difficult to measure in any case – or investment outcomes.
Evidence suggests that increased trading volumes increase volatility, which actually has a detrimental effect on capital formation and investment. In addition, much of the additional liquidity provided by HFT and hedge funds is fragile – present when markets are stable and absent in stressful conditions when it is crucial. This type of liquidity may actually be destabilising and detract from the proper functioning of markets and lead to poor investment decisions.
The case for more liquid markets and greater trading liquidity is similar to the case, sometimes made, for tolerating insider trading on the basis that it increases market efficiency, by allowing non-public information to be incorporated in security prices.
Recent revelations about collusion to rig financial markets in money rates, foreign exchange and commodities illustrate that market manipulation is widespread. The proposition that equity markets are rigged is hardly a revelation.
Manipulation is increasingly also official policy. Government and central bank actions such as quantitative easing (QE) are intended to manipulate the price of sovereign bonds. QE and zero-interest rate policies seek to influence equity prices and even specific sectors such as banking stocks. Intervention in currency markets in combination with QE is designed to manipulate foreign exchange rates.
Institutional complicity is evident. Stock exchanges throughout the world have encouraged the growth of HFT and electronic trading as they now constitute a very substantial proportion of their revenue. They offer "co-location" opportunities allowing traders to position their computers adjacent to the exchange's price-matching engines to gain information and speed advantages over competitors, in exchange for fees.
At its core, the issue is about acceptance of corruption in the functioning of markets.
But is also about trust, or the lack of it – a system that delivers its citizens and their precious and hard earned savings into the maw of a deeply flawed, corrupt and exploitative financial system that is difficult to avoid. Cliff Asness, founder of the hedge fund AQR Capital, was correct when he argued in a Wall Street opinion piece that: "Making mountains out of molehills sells more books than a study of molehills."
Ironically, there may be some unheralded benefits of computer trading. HFT may assist in the elimination of bankers who created the machines in the hope of gaining a trading edge. They may find themselves joining the ranks of the technologically redundant as artificial intelligence takes over trading.
It also poses some important questions: will computers engage in insider trading and, if so, who will the regulators prosecute?
Satyajit Das is a former banker and author of 'Extreme Money' and 'Traders, Guns & Money'
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