Tip:
Highlight text to annotate it
X
**Graziadio Business Report Jingle** DS: Good day this is Danielle L. Scott, Managing
Editor for the Graziadio Business Report Blog. Today is August 12th, 2009 and here with us
is Davide Accomazzo Adjunct Professor of Finance at the Graziadio School of Business and Management.
Professor Accomazzo teachers global capital markets and portfolio management and in 2005
he cofounded Cervino Capital Management where he is the principle trader. Professor Accomazzo
often writes about markets and economic issues and most recently he wrote for the GBR blog
about the subject of today’s interview, the dangers of high frequency trading. Professor
Accomazzo thank you so much for being with us here today.
DA: Thank you. DS: So my first question in layman’s terms
can you tell us what is high frequency trading? DA: Yes because high frequency trading as
a matter of fact, it’s a very general term and a lot of things really go under that umbrella
and generally speaking it’s something that has to do with high velocity trading, computer
driven using very sophisticated mathematical algorithms. There’s nothing really wrong
necessarily with high frequency trading per say it’s just in fact it’s mostly a natural
progression of technology in that never-ending quest for finding liquidity in the market,
providing liquidity in the market and for helping reducing the market input cost for
professional traders, for institutions and for, you know, all kinds of investors. The
problem is with everything, there is occasionally some unintended consequences and also some
outright abuses and that’s why a lot of the media attention lately has been focusing
on this problem trying to figure out whether or not there are in fact some potential danger
issues for the market. DS: So can you tell us about what these potential
danger issues may be and who really stands to lose?
DA: Yeah well who stands to lose basically is pretty much everyone who is involved in
the market, I mean the cost of doing business can be actually instead of being reduced could
be made higher for everyone. The cost of potential disasters in the market like a sudden liquidity
vacuum which I’ll explain in a second what that means, it’s a real issue. Some of the
unintended consequences are such as we progress down the road of, you know, technological
improvements, more and more of the trading is now made through machines and through computers
to the point that some stocks and some instruments, some markets they now trade about 60 to even
90% of their daily volume in an electronic way. Now that is potentially dangerous because
machines do not with algorithms, mathematical algorithms do not necessarily respond to market
conditions and changes in events and in the daily life of markets the same way we human
beings do. So the market structure is changing and that can have really potentially bad,
negative externalities. The other problem that we are now beginning to realize is that
technological advances like this can actually offer cover for potential of fraud, so we
have a number of potential issues like what they call for example flash quotes or teaser
quotes that is something that traders that are engaged in high frequency trading, some
of them have privileged access to for example quotes and they will see quotes for bid or
ask for stock that is put up for sale or for purchase before anyone else that’s an unfair
advantage and they can act upon that quote in, you know, arbitration and unfair profit.
In other case like teaser quotes because we’re now moving from the universe of human being
into a universe of machines, speed is tremendous, we’re talking about milliseconds, stuff
that we cannot even process as human beings. So you have millions of trades are being processed
in milliseconds and we have these teaser quotes where a machine will put out a quote for just
one or two milliseconds just to gauge the market reaction and then the quote will disappear
but by doing so, the machines finds out about the certain interest or not in their particular
stock by other slower traders and then they can act upon that. Again these are changes
in the structure that are not necessarily positive and they can create unfair advantages
for some traders. Not to mention for example that high frequency trading is very expensive
so if, you know, it produces a promise selectivity you can only engage in that type of trading
if you have the resources to buy those very powerful and very expensive machines and also
the collocation fees, the only way you can actually engage in that trading, double trading
is to actually have your machine and your server located at the exchange of one of these
electronic platforms. In that case there’s a very expensive collocation fee that gets
paid to the electronic exchange. Not everyone can of course access that, so now you’re
creating a two tier market where somebody can access that and someone else cannot. Certainly
the retail investor, the normal investor like you and I cannot, you know, cannot really
do that and then there’s also another issue where a lot of the volume that is being created
it’s what I would call toxic volume, it’s not really good liquidity that is being provided
to the market. These traders do not really have scheme the game, the come in and out
of the game, you know, millions of times a day for milliseconds and so all that liquidity
can disappear in a moment so the lobby of high frequency trading that is pushing
and saying “We’ll we’re providing liquidity, we’re providing a service to the market”
which generally speaking can be right but in many cases it’s actually not real liquidity,
just toxic volume that can disappear immediately and probably will disappear when you need
it the most; so you’re running now a risk of a liquidity vacuum which I was referring
to a moment ago where there is a need for liquidity and the volume is just not there,
it just disappears and then you will have a dramatic increase in price. I would like
to remember that in 1987 when we had the crash and the black Monday it was a bad day and
it was going to be a bad day for fundamental reasons but it was never going to be such
a bad day when the market fell about 22% in a day, if it wasn’t for the unintended consequences
of computerized trading and program trading in portfolio insurance that was then and every
time there’s a change in the market structure there can be unintended consequences and I
think this time around we might be running the same risk unless we take some potential
I should say action. Now there’s one more problem that comes with that and I think that’s
outright right illegal and that is the problem with rebates. A lot of this volume is again
it starts if it’s necessary because a lot of these high frequency traders they do not
trade for profit like you and I would do, they trade for rebates meaning that this electronic
exchange is this liquidity aggregators, they will pay a rebate to these traders to just
come and trade on their platform. So if you can actually trade scratcher trade just, you
know, trade for even you will still make money because you get, you know, a fraction of penny
from the exchange just trading. So if you can figure out a mathematical algorithm that
will allow you to trade a million times a day for even, you’ll still end up making
money because you get this rebate from the exchange and now I think that’s a very deceitful
practice because first of all it’s a cost the exchange is bearing, which now will pass
to the customers people like you and I. It creates an incentive for high frequency traders
to trade in an unnecessary type of volume which then rises the risk of a liquidity vacuum.
So again all these issues combined I think that really are changing the market structure
and potentially creating a very negative, you know, outcomes. I mean the SEC’s already
investigating some of those things like flash quotes are now on the red screen. But we know
how have occasionally misguided the SEC has been so.
DS: So they’re investigating but are there any real regulations in place at this point
and if they’re aren’t, what do you think should be in place?
DA: I think there is a number of actually very simple things that can be done to at
least to sort of moderate the problem and again a lot of the issues can be just unintended
consequences, I’m not talking about conspiracy theory here, I mean in any possibly stretch
of the imagination but flash quotes and teaser quotes there are being investigated by the
SEC and it looks like they’re going to be banished so that’s a very good step. The
other problem for example is after the 1987 crash we put on certain things like curbs
and circuit breakers so that if the ___________________ volatility of the market was going to accelerate
then certain circuit breakers will kick in, which will force the machine to shut off so
you can only trade human being with human being and not program trading. I think things
like that may help us slow down the rhythm and the pace of the market should things get
out of hand, I think there would be very much helpful. Rebates I think is a practice that
should be eliminated, I find it wrong and it just incentivates the wrong type of volume,
we’ll see if that happens now. DS: So today, what can we do, is there anything
that investors can do to mitigate the risk of high frequency trading?
DA: Well as a retail investor there isn’t much you can do but I think that the most
important thing is to be aware of the problem to be vocal and to require transparency. I
think one of the major problems with the markets and whether we’re talking about high frequency
trading or some of the other disasters that we’ve been going through in the last couple
of years have a lot to do with the lack of transparency and I think the more we become
engaged in understanding the financial world, our own personal finances and how markets
work the more transparency we will be requiring and I think the better things will work. I
always tell me students for example that we’re at the point where the financial markets have
become so sophisticated that it is no longer possible for anyone to really just delegate
their finance, say “Well I got people so they manage my stuff.” You really have to
be aware of what’s going on, you have to know the situation, you have to understand
the markets, so that you can have the conversation with the people that professionally manage
your money but I think you really have to be on top of the game, you have to demand
transparency that would be the, you know, the sort of the main advice that I would give.
The other thing would be to be extremely careful, until some of these things are fully worked
out and some regulations put in place, I think you have to be as always, very aware of risk
management, whatever you do with your portfolio whether you’re an active trader or a less
active trader, I think that risk management has to be top of your list.
DS: Well Professor Accomazzo thanks again so much for your time and good luck with your
research. DA: Thank you very much.
DS: This is Danielle L. Scott for the GBR blog, find us online at GBR.pepperdine.edu/blog.