Does high-frequency trading change the game?

As long as there have been markets, people have been driven by greed to make irrational investment decisions. When enough people get in on the action, valuations -- the prices of securities -- go haywire, soaring to obscene heights and then crashing in a shower of crushed dreams.

Chasing performance, taking on excessive risk and selling at inopportune times are all as old as capital markets themselves. What is new is the modern regulatory environment and financial innovations such as high-frequency trading. Is today's stock market the same beast it was 20 or 30 years ago?

The more things change

Social and technological upheaval is a recurring theme in the history of mankind and, by extension, the stock market.

"The biggest structural changes in the U.S. stock market were probably the demise of the railways from around 1900 to1929 and then the rise of the financial sector from around 1982 to 2007," says Russell Napier, consultant at CLSA Asia-Pacific Markets and author of "Anatomy of the Bear: Lessons From Wall Street's Four Great Bottoms."

"In short, the history of a stock market is the history of a changing economy, so this can't be said to be a particular unique feature of recent times," he adds.

Today's market is different from the stock market of the 1920s, the 1950s and even the 1980s. High-frequency trading is one explanation why, but it's easier to understand in the context of the evolving financial sector.

Growth of the financial sector

The percentage of the economy devoted to the financial sector has grown since the latter half of the 20th century -- from 4.9 percent of U.S. gross domestic product in 1980 to 8.3 percent in 2006, according to a paper published in 2013 in the Journal of Economic Perspectives by Robin Greenwood and David Scharfstein.

"The sheer size of the financial sector, plus the increased concentration of it since the financial crisis, means that the economy is more prone to costly asset bubbles where risks get both spread to many actors and, paradoxically, concentrated at the same time in the large institutions. So, it is the worst of both worlds," says Gerald Epstein, professor of economics at the University of Massachusetts at Amherst and co-director of the Political Economy Research Institute.

Despite the expanding footprint of finance in the global economy, increasing economic resources devoted to the financial sector may not offer equivalent returns to the economy, according to Adair Turner, the former chairman of the Financial Services Authority in the United Kingdom.

"There is no clear evidence that the growth in the scale and complexity of the financial system in the rich developed world over the last 20 to 30 years has driven increased growth or stability, and it is possible for financial activity to extract rents from the real economy rather than to deliver economy value," he wrote in "The Future of Finance: And the Theory That Underpins It."

Financial innovation

Advocates or fans of high-frequency trading or automated trading say that it narrows the spreads on investments and provides liquidity to markets, which lowers transaction costs for all investors. Because you have all these computers basically tossing out and canceling trades faster than you can even think, literally, the correct price for a security is discovered quickly.

"With speed involved, there is the ability to deploy large amounts of capital in one direction or another. As information comes into the market, the computers react in a certain way and tend to all go in a direction like a herd to get to the right price that should be reflected by the new information. There's oscillation around the theoretical right price," says Wallace Turbeville, senior fellow at Demos.


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