How High Frequency Trading is a Threat to Investors

The new market movers are increasingly becoming less a human economic reality, and more of a cyber-market event. This is because the digital share-trading process is evolving to a level of ultra-fast securities market making that pitches algorithms against one another in a coded competition beyond human decision making. An unsettling result of this are errant trades that cause mayhem on Wall Street. A recent example of this is a capital investment firm named Knight Capital that lost $445 million in less than an hour per Fortune.

The reason Knight Capital lost so much money in one day was because its computer trading programs got outplayed in a way similar to two computers playing chess. Moreover, according to CNBC, Knight Capital stated a market making glitch in its high-frequency trading programs led to erratic high-volume trades. That led to 150 stocks experiencing volatility inconsistent with the broader market trend for that day. This is not the first time an event like this has happened either.

On May 6, 2010, an occurrence widely known as the “Flash Crash” also caused market mayhem, but to a larger extent. Unlike the events caused by Knight Capital, this event began with a commodity market trade by a financial firm. Within just 20 minutes, computer programs contributed to a selling panic that caused market losses to the tune of $862 billion per Bloomberg. The same event is described by the Wall Street Journal as being triggered by “unusual price movements,” “data disruption,” and “unusual trading activity.”

High-frequency trading is making the efficient market hypothesis seem quaint or inapplicable to stock markets in a traditional sense. Moreover, since digital trading algorithms are currently competing in a different kind of efficient market amongst themselves, the meaning of efficiency changes from  valuation made by humans to the most advantageous trading by software. Additionally, according to the New York Times, high-frequency traders are able to unlawfully influence share prices to their benefit making regulation of the practice all the more important. Left unregulated, there is little to stop such trading from causing market mayhem either deliberately through erratic trades, or unintentionally via errant trades.

In February 2012, the Commodities Futures Trading Commission decided to form a sub-committee on high-frequency trading. Whether or not regulatory moves such as this will have any effect will at least partly depend on how well they read and interpret computer code. What events like that of Knight Capital imply is that market price movements are increasingly being defined by high-frequency trading programs. When high-frequency trading algorithms out-compute one another, they are capable of doing so at the expense of investors, and this compromises corporate decision to the point of disabling lack of control.