Another week, another Wall Street scandal, and another opportunity for pundits to bemoan the incompetence and venality of America’s financial professionals. Last Wednesday’s near collapse of Knight Capital Partners – in which a bug in one of its high-frequency trading algorithms caused the firm too loose $440 million – has raised concerns about high frequency trading and what the practice means for the safety and trustworthiness of our financial markets. But what is high-frequency trading, and is it really all that dangerous?
High frequency trading is a catch-all term that describes the practice of firms using high-powered computers to execute trades at very fast speeds – sometimes thousands or millions of trades per second. These systems have developed over the past ten years, and began to really dominate Wall Street over the last five. For example, a high-frequency trader might try to take advantage of miniscule differences in prices between securities offered on different exchanges: ABC stock could be offered for one price in New York and for a slightly higher price in London. With a high-powered computer and an “algorithm,” a trader could buy the cheap stock and sell the expensive one almost simultaneously, making an almost risk-free profit for himself.
At first blush, it appears high-frequency traders have done what market observers generally like, which is increase the amount of trading going on at any given time (what traders call volume) and the ease with which someone can buy or sell a given security (commonly known as liquidity). Basically high-speed traders add to the overall action in a market, which, at least theoretically, is supposed to make markets more accurate and efficient.
But not everyone agrees that the thousands of extra trades per second that some computer algorithms are executing are actually all that good for the market. In a recent paper titled, “The Dark Side of Trading,” Emory University accounting professor Ilia D. Dichev argues that while some high-frequency trading can be beneficial, the scope of high-frequency activity in the market today — which accounts for up to 70% of all trades by some estimates — has drowned out the input from more traditional investors who partake in good-old-fashioned “fundamental” analysis of companies, i.e. the analysis of financial statements and business plans.
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