Goldman Sachs Economic Research is out with a hefty note on global markets, and the hazards present in liquidity-sucking algorithmic trading, also known as high-frequency trading, or HFT.
Key quotes
“Why liquidity risks may be rising: As we first noted after the VIX spike in February, the rising frequency of “flash crashes” across many major markets may be an important early warning sign that something is not quite right with the current state of trading liquidity. These warning signs plus the rapid growth of high-frequency trading (HFT) and its near-total dominance in many of the largest and most widely traded markets prompt us to more carefully consider the possibility (not necessarily the probability) that the long expansion accompanied by relatively low market volatility may have helped disguise an under-appreciated rise in “market fragility.”
HFTs know the price of everything and the value of nothing: One theory that has been proposed for why market fragility could be higher today is that because HFTs supply liquidity without taking into account fundamental information, they are forced to withdraw liquidity during periods of market stress to avoid being adversely selected. Despite this disadvantage under stress conditions, their informational advantage over human trades under normal conditions has allowed them to grow to become the dominant liquidity providers in all of the largest, most liquid markets. In our view. this at least raises the risk that as machines have replaced people, and speed has replaced capital, the inability of the market’s liquidity providers to process complex information may lead to surprisingly large drops in liquidity when the next crisis hits.
Future flash crashes may not end well: While we focus on one particular theory for why “trading fragility’ may be rising (namely, adverse selection), we see other risks that are in some sense more obvious. For example, the substitution of speed for capital means that ever larger amounts of trading volume are backed by too-thin capital cushions; liquidity supply could collapse on a large operational loss. Alternatively, if a flash crash were to occur against a more negative macro backdrop, it could inadvertently reinforce the market’s interpretation of “bad news.” Given the rapid evolution of the market. there are many other possible reasons to worry about a rise in trading fragility. not least of which are the “unknown unknowns.” “
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