Keynes, himself a successful investor, was alert to the danger of a disproportionate level of speculative activity. His oft-repeated remark:
Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.
For many activities, what is virtuous or at least harmless in small does becomes detrimental at a larger scale. Speculation is generally considered to be valuable, or at worst neutral in its effects, because speculators provide additional liquidity to markets and often provide a counterweight to prevailing investment points of view. But excessive speculation results in prices unanchored from fundamentals, which can send false signals to the real economy. And if investors believe that financial markets are in the control of a small handful of pros that have an advantage over them, they can and will retreat to the sidelines. We see that in the US equity markets now, where retail investors are increasingly distrustful of reports of high frequency trading, the May 6 flash crash, and overly frequent pronounced end of trading day price moves, which look suspiciously like traders successfully pushing the markets around. They’ve moved to the sidelines in the face of a rally.
The latest spectacle is a push to derail efforts to curb overly speculative behavior, one of which is high frequency trading. There is ample reason to believe it played a critical role in the flash crash, much as program trading did in the 1987 crash. However, in 1987, program trading quickly became a dead letter, since the strategy failed to help stem losses as advertised. By contrast, because trades at super low prices that resulted from automated selling in the flash crash were canceled, speculators did not have their fingers burned; indeed, they’ve now learned if they really screw up, the authorities will come to their rescue. Indeed, today the New York Times reports that flash crashes continue, but in individual stocks, not across the entire market.
Not surprisingly, having become a financial force to be reckoned with, high frequency traders are fighting to preserve their questionable practices. Per Bloomberg:
Closely held companies with undisclosed profits and obscure names like Getco LLC, Hard Eight Futures LLC and Quantlab Financial LLC, are beginning to act more like Wall Street banks, cutting checks to politicians, forming trade groups and hiring lobbyists and ex-regulators. They’re looking to fend off tighter rules and appease lawmakers who say the firms disadvantage small investors and contribute to wild swings in stock prices.
While the companies, which use high-powered computers to execute thousands of trades in milliseconds, aren’t approaching the big banks in Washington spending, they have more than quadrupled their political giving over the last four years, a Bloomberg News analysis shows. The top recipients include Eric Cantor, set to become House majority leader, and several incoming senators who won in last week’s Republican rout.
“They are under attack as an industry and they are fighting back,” said James Angel, a professor at Georgetown University’s business school who is on the board of Direct Edge Holdings LLC, which operates stock exchanges. “There is an old saying in Washington that if you are not at the table, you are on the table.”
In just over a decade, high-frequency trading has evolved from a little-known investment strategy practiced by mathematicians to a force that accounts for the majority of U.S. stock trades. The companies, which prefer to be called automated proprietary trading firms, say they benefit all investors by keeping markets liquid and transaction fees low.
This spectacle is hardly new; we saw the major banks fight (and continue to fight) to block and water down legislation such as the Volcker Rule, whose intent was to limit government backstops to the socially useful parts of market activity, namely, market-making. Despite their efforts to claim they also serve a socially valuable role, HFT instead does not involve direct customer order facilitation. Even worse, it appears to exacerbate swings in liquidity, increasing it in robust times and withdrawing it when market volatility moves outside certain parameters.