This is a unique time in the history of mankind because so many get to speak publicly about subjects they do not understand at all and the blogosphere and electronic media is giving them this opportunity. Adversely hit by this high entropy of low quality information flow are especially the markets where in the last few years the media has been on a crusade to discredit them using as an excuse High Frequency Trading (HFT). The result has been a substantial decline in the number of participants and lack of liquidity.
Those who understand the markets and how trading operates also understand that HFT was a natural evolution of the old open outcry and market making paradigm. Everything is going faster nowadays because of the advances in Information Technology and the markets could not escape this evolutionary stage. Ten years ago the “locals” paid hundreds of thousands for a seat at an exchange and for having knowledge of the order flow. In exchange, they offered liquidity when it was needed by assuming counterparty risk. This structure was naturally displaced by faster and faster machines when screen trading replaced open outcry. The high profits of HFT firms came as a reward for providing liquidity to retail traders and investors. In the same way that a “local” had to be on the floor to have knowledge of order flow back in the open outcry days, HFT computers had to be collocated with exchange computers to have timely knowledge of the changes in the order book.
The media, many envious traders who have not managed to profit from the markets and have turned to bloggers, and several other groups, including socialists who hate the free markets, self-proclaimed saviors of the world, etc. started on a crusade to convince retails traders and investors that HFT is ripping them off and can cause flash crashes and that they should stay away from the markets. While lacking even a basic understanding of how markets are structured and operate, they could not even answer the following simple questions:
(1) How can HFT rip-off traders and investors who use limit, MOC or MOO orders?
(2) What difference does it make to a longer-term investor if he buys 1,000 GOOG at $861.15 instead of $861.14, supposedly because of HFT driving the price higher? Twenty years ago commissions rates were 10 times higher than today and nobody complained that brokers ripped-off investors. I recall futures traders paying as much as $50 each side 20 years ago and stock traders paying as high as 0.5% per trade.
(3) Why there was a crash in 1987 when computers were nowhere near as fast, HFT did not exist, and orders were mainly typed in?
These are just a few of the questions those attacking HFT and trying to convince the public not to participate in the markets have never answered. Actually for some of them HFT is an excuse, a vehicle or a straw man, for their hidden agenda to undermine the free market.
The worse of all is that the media has convinced politicians to enforce tighter regulations and establish monitoring systems in the markets for that purpose. The systems can potentially label any participant who operates a sophisticated algo as a manipulator because of vague market regulations. Such a system was described in a recent article in Bloomberg Business Week, which talks about the decline in HFT profitability.
In a recent blog post I have shown that nearly 3 out of every 10 traders who used a coin to establish long/short position in SPY have profited. This is much better than any gambling system can offer. Participation in the markets not only has high probability for profit but also assists in efficient price discovery in a capitalistic system and thus optimal allocation of resources. Attacking the markets is a direct way of attacking price discovery and causing mispricings. Even those who lose in the markets because someone who is smarter or luckier takes their money eventually gain because the participant that profits at some point returns the money back to the system in the form of consumption or trading losses. Trading is a very useful zero-sum game, essential for the proper operation of the capitalistic system and attacking it using as an excuse HFT, a natural evolution of pit operations, is a direct assault on free markets. The media along with some of the other types I mentioned in the beginning of this article have done a good job in achieving this objective over the last few years.