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Companies issue stock to raise capital to grow their businesses. Investors purchase stock to participate in this growth. The stock market enables investors to buy and sell stock immediately and at transparent prices, making it the most-efficient device developed by man to allocate that scarce resource: capital.
That’s how it was—before the machines took over. Much like the fictional Skynet in the “Terminator” movies, firms engaging in “high-frequency trading” have unleashed a torrent of unbridled technological firepower that seems to have overwhelmed its human makers’ ability to control.
Left unchecked, high-frequency trading could threaten the very foundation of the stock market as a venue where companies go to raise capital and investors determine which companies to back.
High-frequency firms use powerful computers to implement complex, quantitative trading algorithms that seek to exploit the tiniest (fractions of a penny) price discrepancies that appear and vanish in milliseconds. Computers place and cancel thousands of buy-and-sell orders in the blink of an eye. Firms may hold a given stock for seconds or minutes, but never past the end of the day.
This clearly bears no resemblance to investing in the usual sense, so why should traditional investors care? First, high-frequency trading firms account for more than half of the volume in U.S. stocks. Second, when these firms and/or their computerized trading algorithms malfunction, they tend to do so in spectacular fashion.
Most investors had never heard of Knight Capital Group before Aug. 1, but it is one of the largest firms on Wall Street, accounting for about 17 percent of trading volume. Knight rolled out new trading software that morning. In the opening 45 minutes, its computers entered thousands of erroneous trades in almost 150 stocks, purchasing $7 billion of stock by mistake. Knight lost $440 million selling the positions, pushing the firm to the brink of insolvency.
NASDAQ OMX Group bungled the wildly anticipated Facebook IPO in May. NASDAQ’s computers were overwhelmed by orders and unable to confirm trades for several hours, leaving investors in the dark. Not to be deterred, the computers at UBS AG continued to place duplicate orders and bought 50 times more shares than intended, leading to a $356 million loss. Ironically, Thomas Joyce, CEO of Knight, exorcised NASDAQ for the snafu.
BATS Global Markets, operator of an electronic exchange, wanted to showcase itself as a listing and trading venue by listing its own IPO in March. Chaos ensued. With its stock crashing from the $16 IPO price to pennies, BATS was forced to cancel its IPO, making a mockery of its acronym for Better Alternative Trading System.
High-frequency trading has reduced transaction costs for traditional investors by narrowing the bid/ask spread. It also provides trading liquidity to the market during calm periods. However, the cost of lost investor confidence might be starting to outweigh the benefits.
The arms race among high-frequency firms racing to capture those fractions of a penny is growing more intense. Firms are making huge investments to gain 5 milliseconds of speed, which will lead to increased danger, particularly with machines talking to machines.
Beware of Frankenstein’s monster.•
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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.
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