In the middle of a spirited online debate on the pros and cons of High-Frequency Trading, and whether those traders working exclusively from mathematical algorithms were aiding the cause of price discovery or causing causing unnecessary fear in markets, someone asked: “so why the excessive volatility[?]” I could not resist responding. The following is an expanded version of my comments:
We have excessive volatility because it is the interest of trading firms to encourage it, that’s why. And since all of today’s banks have huge trading operations, which generate a large share of their profits in good years, whenever they talk to clients or to the news media, they all encourage volatility. With low volatility, they would soon be out of a job. And before that, their bonuses would evaporate. Again, the question must be asked, is all this volatility helping or hurting the fundamental function of markets (which, contrary to widely held belief, is NOT to make a relatively few traders rich)? If the volatility is harmless—hey, why not? But if it is harmful, if it makes it more difficult for the economy to expand because economic producers cannot raise capital in the markets at fair prices, or savers are afraid to commit their money to economically productive enterprises because of the terrifying lurches in the market, then it should be curbed.
One can argue that the markets ought to be volatile due to the uncertainties of the present economic situation. But the present economic situation has been pretty static for quite a while: there is news flow, but no real change in the outlook, which remains somewhere between very sluggish growth and a modest (but discouraging) further contraction. What real news should induce investors to be 3% more optimistic one day, and 4% less optimistic the next? The largest part of the market volume is algorithmically driven (HFT alone is 56% according to TABB, an association of quantitative traders, and this does not include the huge volume in other quant strategies involving ETFs and other non-economic market correlations); there are no fundamental convictions involved, nor any view of the markets lasting beyond tomorrow. So what useful function is all this volume serving aside from providing an income to traders? Worse, since many of these quant strategies are zero-sum games, there is no net gain to the economy.
Has anyone done any comprehensive studies of whether all these new forms of trading add to or subtract from the original function of markets? I haven’t seen one; academics just assume that liquidity equals efficiency. Nor have they ever conceded that markets can be hyper-efficient (i.e., over-react), which anyone who has ever been a portfolio manager knows to be a common phenomenon. And everyone loves to forget the great market crash of 1987, which presaged nothing, and where most of the liquidity was provided by computers trying to sell enough options to make up for the gaps down in share prices. (They never could catch up. If the market had been open another hour, it probably would have fallen another 20%.) This form of portfolio insurance is now remembered as a ‘success’ by its academic inventors, but it was a dismal failure for anyone who put any money into it.
One would know none of this from reading the public statements of senior bankers against restrictions on their proprietary trading or any other fundamental changes in the structure of our capital markets. In response to ex-Fed Chairman Volcker’s call for ring-fencing and reduction of these activities, the Administration has been waffling, while the bankers say, ‘Over our dead bodies.’ Many of these same bankers were members of the blue-ribbon Council on Jobs and Competitiveness which recently called for severe curbs on Sarbanes-Oxley’s auditing requirements, and which received President Obama’s unqualified endorsement; this despite the horrendous accounting scandals we have had which defrauded millions of investors of billions of dollars, and precipitated at least one major market decline, as well as making the Great Crash of 2008 possible. How likely is reform of our markets when both major parties seem to share this Panglossian view that we have the best of all possible capital markets in this best of all possible financial worlds?