The Broader Market

by Jordan Eizenga

Given that most readers should be away from their computers and enjoying their long weekend, this post will be brief.

Bloomberg Businessweek ran an article addressing the May 6th financial market volatility.  Three weeks ago, The Broader Market ran a clip from CNBC of the 15 minutes of infamy in which the Dow Industrial average plunged 9.2 percent only to recover almost the entire loss by the end of the trading days. Since then, the Securities Exchange Commission and the Commodity Futures Trading Commission have been investigating the causes for the volatility.  SEC Chairwoman Mary Schapiro’s recent remarks suggest that the SEC has yet to reach a determination on the cause for the May 6th volatility. 

One explanation for the sudden drop in stock prices is that, in the midst of large short selling, high frequency trading firms stopped trading altogether.  High frequency traders (HFTs) are traders that use complex computer algorithms to find mis-pricings in securities.  They trade in and out of positions sometimes several times in a single second.  Accordingly,  HFTs have no interest in the companies whose stock they trade - they are merely trading on the basis of abstract market data.

On May 6th, as non-HFTs became spooked at the Greek debt crisis, unclear job numbers, and a series of other negative economic indicators, a disproportionate number of sell orders began to accumulate.  This drove stock prices lower.  HFTs began to take notice and stopped trading.   This was largely due to a concern that exchanges, recognizing anomalous prices, would cancel trades.  Thus, HFTs have been criticized along two separate lines for their role in generating recent volatility: first, HFTs, in making trades that are in a no way a reflection of their interest in the companies whose stocks they trade, can facilitate speculative and irrational trading behavior; second, when HFTs pulled their trades, they evaporated much of the liquidity in the market, which can exacerbate a down market. 

The two criticisms are actually opposing positions; the former criticizes HFTs on the basis that they are, effectively, over-trading, while the latter implicitly criticizes HFTs on the basis that they are under-trading.  That being said, most regulators adhere to the belief that speculative over-trading is endemic in the market.  For this reason, the idea of a tax on equity transactions has been proposed.  The proposal has positives and negatives.  On the one hand, the tax should reduce the number of individual trades and should motivate traders to hold their positions.  This will likely incentivize a return to a focus on the fundamentals of the company being traded.  On the other hand, a tax will reduce market liquidity, which could set out to produce exactly what it aims to prevent - market volatility.

Regardless of the merits of the proposal, the perspective of regulators is correct: something has to be done to reduce the recent wild ride that is our financial markets.

Enjoy your weekend.