Re-thinking the role of short-term trading in financial assets: Keshav Thakkar
The global financial system has come a long way since the days of the trading floor. Technology has played an amplifying role to not only bridge geographies, but also opening up new trading frontiers. From traders being intermediaries primarily back then to using complex mathematical algorithms to trading, I believe somewhere we need to re-think the role of trading in today’s markets.
Firstly, I must clarify that this is not targeting the current decline in equity volumes, which have in fact reduced since the crisis, but to re-think the overall secular increase in equity volumes and also the greater share of high-frequency trading in the total volumes, as estimated by the Bank for International Settlements (BIS)
Regulators like Mary Shapiro of the SEC, as well as Jean-Claude Trichet have publicly expressed concern with not only the magnitude of high-frequency trading, but also whether these high volumes are counter-productive to the financial system as it stands today. Mary Schapiro believes that a bulk of the trading volumes has little to do with ‘the fundamentals of the company that’s being traded’. It had more to do with ‘the miniscule aberrational price move’ that computer-assisted traders with direct connections to the exchange can ‘jump on’ in fractions of seconds. Guillermo Ortiz, ex-governor of Mexico’s Central bank, questions “Does it help to better allocate resources, does it help distribute risk better, or are we just talking about bets that are being taken in the financial sector and have nothing to do with the real economy?” However, market participants such as traders firmly believe that their activities help keep the markets very liquid and reflect the best and latest information, publicly available.
Liquidity vs. Momentum
There is no denying the benefits that liquidity has brought to the financial system, keeping markets efficient in one way, however, it is important to realize that very little of the actual trading volumes are fundamentally driven. And to think of momentum based trading to keep markets efficient would be a major fallacy. What has re-inforced regulatory scepticism especially after the Lehman Crisis of 2008, is that not only does liquidity in markets become tight in the event of a wild downtick, but it also turns out to be reflexive and a ‘self-fulfilling prophecy’ when traders hardly dare to tide against the current, thereby destroying the very purpose of efficient markets. Also, excessive trading often leads to over-reaction to news flow, and pro-cyclical swings in prices.
Many traders argue that because of the higher trading volumes and advent of technology, trading costs have drastically reduced over the past decades. Yet it would be fair to say, that trading does put costs on institutional order executions, thereby redeeming part of the benefits it brings. Also, to think of trading as a zero-sum game eventually, it is hard to imagine how so many traders survive at the expense of other traders. Surely, there is a hidden cost to the real economy from such trading activities.
Figures above are in 000s of shares. Average daily volumes of each year are used
Given these shortcomings, yet it is impossible to conceive a successful capitalist economy without liquid markets. And for maintaining a balance that is rapidly tilting towards high-frequency trading (liquidity), rather than fundamentals, it is time to consider one of the following alternatives :-
- Fewer trading days/hours- this will reduce the scope for over-reacting to news flow. It will enable the fundamental/value investors to analyze their decisions and be on a better platform against the high frequency traders. It reduces the need for too much liquidity in the markets with lesser trading time. The fact that major policy decisions are often pushed to the Friday closing of markets, supports this alternative, suggesting that given the time to reflect upon events, markets may take a more objective stance by way of price movements. It could very well curb volatility to a certain extent, given that we see meaningless moves in prices in many sessions only to be reversed in the next session.
- Financial Transaction Tax (Tobin Tax) – This alternative was very seriously considered by the European leaders in 2010-11, but fearing the uncertain consequences of this tax, potentially threatening the drying up of liquidity in poorly performing markets, this is now put on hold for review at a later date. However, this could be the key to re-shifting the balance in the future towards more rational, fundamental driven trading.
- Penalty for large order cancellations – Being considered by the SEC currently, this targets a lot of the algorithm driven trades meant to be standing purely for high-frequency trading purposes, which are quickly cancelled in the event of a price turn, thereby potentially misleading prices. However, the obstructions this could pose to efficient markets still stand untested.
Although these may be novel and bold steps, it is in the interest of the long term health of the capitalist system that policy-makers should acknowledge the current scenario and take the bold leap in one of these directions. Otherwise, it may be too late to save the system. Perhaps, a co-ordinated effort at a multi-lateral body could be a good starting point.