High-frequency traders are a threat to markets as they “know the price of everything and the value of nothing,” according to Goldman Sachs, quoting Oscar Wilde.
Computers are prized for their ability to process massive amounts of data better than humans. But it’s their relative inability to process a complex world that might lead machines to worry that humans know something they don’t when markets go haywire — and exit a situation in which they don’t have the upper hand, wrote strategists led by co-Chief Markets Economist Charles Himmelberg in a note.
There’s an old poker adage that if you can’t spot the sucker at the table in your first half hour, it’s probably you. The same thinking informs why HFTs tend to withdraw in chaotic markets, according to Himmelberg.
“When shocks of unknown origin cause sudden price declines, HFTs may have reason to assume that the shock is being driven by fundamental news (e.g., if the price decline follows a complex macro surprise or dramatic policy announcement),” the strategists wrote Tuesday. “Under these circumstances, HFTs are at higher risk of being adversely selected by more fundamentally informed traders, so their optimal response is to withdraw liquidity by widening their quotes or by withdrawing them altogether.”
This can cause a feedback loop if the selling continues, leading to a lack of liquidity and thus bigger price declines, which drives HFTs to supply even less liquidity and in some cases even aggressively demanding liquidity, according to Goldman.
Thus, the increasing popularity of algorithmic trading may be making markets more fragile. Indeed, abrupt “flash crashes” have occurred across stocks, fixed income, foreign exchange and volatility markets since 2010 amid this rise of the machines.
Computerized trading comes with other risks. There’s little capital backing the most of these operations and a quick withdrawal of liquidity by HFTs could reinforce the negative perception of a macroeconomic event, adding to a vicious feedback loop, according to Goldman.
“Vulnerabilities in the new market structures are under-appreciated simply because they have not yet been stress tested by this long expansion,” Himmelberg wrote. “To us, the rapid growth of financial innovation and market share of HFT liquidity supply during the post-crisis period feels uncomfortably familiar.”
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