To behave nobly and heroically in an obviously hopeless cause is a kind of folly, but it can also constitute a kind of greatness. Despite the wrongheadedness of the enterprise, an air of transcendence arises from their sufferings. It was in vain that they died, but their deaths raised them up, as it were, and made them emblems of whatever it is in human beings that can seem sublime.
– Anthony Brandt,The Man Who Ate His Boots. The Tragic History of the Search For the NorthWest Passage
For the better part of the 19th century the British Navy was on a quest, a relentless search for the Northwest Passage. It was an elusive goal to find a sea lane through the vast arctic ice across North America to the Pacific. How can one not have a deep admiration for those brave souls who trekked out into the frozen unknown in search of a dubious goal for God, King and Empire? They had nary a safety net that would be available to any such voyager today. No GPS, no GORE-TEX, none of the vitamin-rich packaged super foods and no helicopter rescue team. In hand nothing but their own wit, sheer determination and a bit of luck as they stared out over the vastness of endless ice with frostbitten fingers. Would they ever safely navigate its enduring bergs and shifting floes with sail, compass and the stars to guide them? Of course they never did, eventually giving up due to the exorbitant cost and too many brave souls lost, but certainly not for lack of courage, fearlessness or enduring effort.
In the volatile days of August a steady rain of accusations fell. High frequency trading bore the brunt of abuse for the market’s irrational behavior from pundits and media alike. On any given day, one could find a wealth of articles with phrases or headlines such as: fraught with hazard, operating in the shadows, seizing the best deals at the expense of ordinary traders, we need to cage the cheetah’s, no redeeming social and/or economic value. The list of cold commentary is endless. It makes me wonder when the hordes, pitchfork in hand will stampede yelling ‘Kill the Beast’. Such frosty behavior looks to celebrate a collective vengeance against HFT firms not seek justice for what ails. Many are intractably opposed to HFT, that HFT is bad for the markets has become endemic. Art Cashin called the market’s steep drop “a classical technical breakdown” and said high frequency trading was contributing to the decline. Doug Kass rages against machines as “too fast and too stupid… humans are smart enough to avoid a massive selloff like we had… [machines] obviously don’t care about the fundamentals behind the numbers…“. They would have us retrogress to a time when all trading was conducted by people sans machines. So what has fueled all this negative sentiment against HFT? As David Brooks highlights, behavior that seems altruistic is really self-interest in disguise. We’re bascially selfish creatures able to act altruistically only when we stand to gain. August’s declines caused the market to lose billions in wealth while HFT firms racked up daily profits from $60m to $200m. It’s hard to ignore the creation of an ideological difference in attitude, fueled by losers who vehemently disagree to any notion of profiting from a losing market. But long term, no one wants that. It’s a losing proposition for all participants and the global economy.
What is happening? A chilly reminder of increased regulatory control and oversight. The result of the crusading commentators has pressed the SEC and FINRA to ask high-frequency trading firms to hand over the details of their trading strategies. This amounts to revealing their highly guarded intellectual property, something they are loath to do. I’m sure the HFT luddites are wringing their hands. Yet armed with this information even from numerous firms, the regulators still face the difficult problem of determining market impact. Can they extract the human element from market volatility in their analysis? As Phil Pearlman describes “Periods of extreme price volatility have occurred for as long as there have been markets and they will continue to occur periodically as long as humans are involved“. And what about all those other emotional fears driving the markets? The Dow Jones Industrial Average fell more than 400 points on the day when the Philly Fed survey for August was announced. Investors panicked. When H-P announced a management shake-up, lowered its outlook and dumped the Touchpad, the stock dropped to a 6-year low. Investors panicked. Impulsive investors rush in and out of the equities, gold and bond markets as fears of a double-dip recession, bleak jobs reports and the ebbs and flows of destabilizing debt in the US and Europe rise and fall. Thank god machines are not interested in fundamentals (I say that facetiously of course, in regard for those sentiment-based news and social media strategies).
There are so many market mechanics that can contribute to volatility. On any given day as declines build, stop-loss orders trigger further accelerating the drop. And as Matt Samelson so eloquently outlines “short-covering begins …” which itself is another trigger point that reverses the price direction. Enter in the human emotional factor; the panicked institutional and retail investor, the short selling circuit breaker which causes market rebounds every other day, as Steve Wunsch describes and you have the recipe for a whipsaw market, inviting pundits to scream for a scapegoat and catching the icy glare of suspicious regulators.
Yet what is HFT’s role in all this? “In any 5 minute period, I am buying as much as I will sell … By the end of the day, I will be flat“. a basic model of nearly any HFT strategy as mentioned in a recent CNBC commentary. The empirical evidence to determine if such models are the cause of market volatility was recently published by Alex Frino, chief executive of the research group Capital Markets Cooperative Research Centre. His research indicated that HFT may actually decrease price volatility. This is not the first research paper published that indicates such findings. Yet despite the factual affirmation, there remain philosophical differences based on prejudged opinions creating an impasse between the HFT firms and those pitted against them for the reasons I mention above. It’s simply a matter of ideology. Factual evidence aside, there is not much of a chance to sway an opinion. A better path is to concede and cooperate.
While August’s volatility is not analogous to the May 6th flash crash it nonetheless puts the regulatory authorities under pressure to gain better control and understanding of our markets to ensure market integrity for all participants. To that end, the SEC and the CFTC have plans to expand their headcount in the coming year by nearly 1000 employees. No doubt they will fill positions to accelerate the implementation of Dodd Frank, but also are likely to focus on the development and deployment of the Consolidated Audit Trail by which they hope to be able to conduct the needed research to determine the cause of market anomalies. As the cold-hard facts of current research have already shown it will affirm that HFT has brought some benefits to the market. Yet for the detractors to concede HFT’s benefits, transparency and cooperation with regulators will be needed by the HFT firms. For the benefit of all participants there has to be an incentive to work collectively, even against short-term self-interest.
It was the August winter of our market’s discontent. Yet the storm is far from over nor is the voyage done. Those intrepid arctic adventurers of long ago that sailed through the unchartered vastness of ice were out to prove more than the existence of sea route across North America but that it was a commercially feasible one. It took nearly 200 years and global warming to reduce the pack ice enough to make the waterways navigable. Let’s hope it doesn’t take that long to navigate through the volatility.
Once again thanks for reading.
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