Friday, September 28, 2012

High-frequency Trading & Capital Formation

From this article on high-frequency trading:

High-frequency trading insanity

...the high-frequency trader, deploys massive computer capacity and complex algorithms to buy and sell individual stocks multiple times in a fraction of a second, all in search of micro-profits with each trade. This trader cares not a whit about a stock's fundamentals.

In a sane world, high-frequency trading would be a minor specialty at best. But in the bizarro world that Wall Street has become, such activity now makes up the majority of all trades. It is manufacturing risk while siphoning money and talent that growth-producing sectors of the economy need.

Then a bit later in the article:

...these practices undermine the core purpose of markets, which is to raise capital in pursuit of enterprise, profit and economic growth.

In his latest book, John Bogle points out that there are more than $ 30 trillion worth of trades each year, yet fresh investment of capital into things like businesses, new technology, medical breakthroughs, plant and equipment is less than 1/100th that amount (~ $ 250 billion). So our equity market system now has more than 99 percent speculation for less than every 1 percent of actual capital formation.*

With those numbers in mind, I don't think it's unfair to say we have more than enough liquidity. These traders, not surprisingly, don't quite see it that way.

The traders argue that they add liquidity to markets that lowers transaction costs and eases dealing in thinly traded shares. There is some truth to this. But the negatives far outweigh the positives.

It's certainly the case that markets need enough liquidity. I think it's safe to say we're well beyond having a shortage of liquidity when pieces of businesses are being bought and sold in fractions of a second over and over again.

We need an optimal amount, not an unlimited amount.

Eventually, more isn't better.

Once there's enough liquidity, the focus ought to be reducing the cost of capital and improving capital formation. Getting capital to where it is needed most to fund crucial investments.

Those who buy/sell in high volumes obviously benefit greatly when the cost of each transaction goes down. Those with a longer term horizon who trade infrequently the absolute minimization of transaction costs matters less. So the lowest possible transaction costs is naturally a top priority of a highly active trader. Yet market's don't exist to serve traders.

They exist to support the formation and development of enterprise in the real economy.

Equity markets are there (or should be) to help fund the creation and expansion of businesses. Naturally, low transaction costs and enough liquidity matters to a varying extent to all participants, but that focus is too narrow.

For businesses in pursuit of opportunity, lowering the cost of capital and enhancing access to capital is far more important.

My vote is for more emphasis on whether markets are structured to increase the probability that capital is directed to its highest and best use.

That dollars in enough scale are meeting up with good ideas and talent.

After all, that's the reason the equity markets exist in the first place. At the present time, there's more than enough liquidity. Transaction costs are hardly at levels that hinder progress in the real economy.

If all this added liquidity is actually lowering the cost of capital then it's a useful thing. If, instead, it is creating added volatility, as it surely seems to be, and instability (perceived, real, or a little of both...fear of the next flash crash when some unforeseen scary macro event inevitably occurs), then it has the potential to raise the cost of capital if participants who might otherwise put their capital at risk are less willing to do so.

Liquidity is also a good thing as it helps to generally set market prices closer to the per share intrinsic value of the underlying businesses. Frequent and substantial mispricing ultimately leads to capital misallocation. Well, if as the article above suggests, the high-frequency variety of trader "cares not a whit about a stock's fundamentals," and that their activity "now makes up the majority of all trades," it seems unlikely they'll make a useful contribution to the discovery of a fundamentally rational market price relative to per share intrinsic business value.**
(Realistically, it would always be more a range of prices. It's not like wide fluctuations could ever be eliminated in the equity markets. The simple reason being that there's no way to ever perfectly judge what intrinsic per share business value actually is. The range is necessarily especially wide for shares of certain more speculative businesses.)

So, at least in today's market, apparently the bulk of all trading comes from those basically uninterested in underlying business fundamentals.

With so few interested in underlying fundamentals, how do we not end up with stocks becoming mispriced more often in that environment? How do you not end up with a market environment where capital is frequently misallocated?

Most answers to those two questions seem destined to be, at best, rather contorted.
(Though those with enough creativity, motivation, and vested interest in the status quo could no doubt come up with a good way to answer these questions.)

The markets exist to help facilitate capital formation for businesses so they can more ably pursue productive enterprise. Markets operate below their potential when they become a hyperactive, casino-like, atmosphere more interested in serving its active participants (those primary interest is near-term price action) instead of the entities that need capital to fund their opportunities.

I'd like to see some evidence that high-frequency trading makes it easier for corporations to efficiently raise capital and/or that it lowers the cost of that capital. It seems likely that all this added hyperactivity does little in that regard and, instead, mostly just adds a bunch of frictional costs to the system as a whole (even if it happens to lower the cost for certain participants.)

Those costs are effectively a tax on capital formation. Yet the biggest cost might be all the talent high-frequency trading takes away from more value added endeavors.

Here's a report by the Federal Reserve Bank of Chicago for more background on the concerns surrounding high-speed trading and keeping markets safe. Also, last week a senate panel looked into this.

Washington Post: Senate panel looks into high-frequency stock trades

According to this article, the Federal Reserve has concerns about how market structure is impacting their easing policies. Programs like quantitative easing depend on the markets functioning well.

Finally, the SEC is supposed to hold a meeting next week on this in an attempt to figure out just what to do about it.

I'd prefer to think otherwise but it doesn't seem likely much of this will be fixed anytime soon.

Adam

* In this essay, John Bogle cites slightly different numbers. He says that annual stock trading volume is $ 30 trillion while average annual new issues of common stock is $ 145 billion. So trading represents more than 200x the amount of equity capital that's provided to businesses.
** I personally like it when stocks get mispriced but frequent and substantial mispricing ultimately leads to capital misallocation. So I'm speaking in terms of what's the best way for equity markets to promote enterprise not how to make life easier for participants who seek out mispricing in the equity markets.
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