High-Frequency Trading to Blame for Market Volatility? 

Global regulators are said to be looking at the wilds swings in the stock market and once again discussing the role played by high-frequency traders in the volatility. With no conclusive evidence of what's causing the dizzying gyrations -- 1 percent or 2 percent swings, often during the last half-hour of trading -- there's a lot of finger pointing going on.

The volatility has been vicious, and while it often has been linked to fears over a European debt default by Greece or signs of a weaker U.S. economy, a precise financial driver has been elusive. On Tues., Oct. 4, in fact, instead of a meltdown, the market had a "melt-up," when the U.S. stock market surged 4 percent without any obvious reason.

Some market watchers grasping for explanations for the whipsawing moves are blaming leveraged exchange-traded funds, or ETFs, which allow investors to go long or short on a basket of commodities or stocks or an index, for the late sell-offs and rallies. A recent New York Times DealBook column, "Volatility Thy Name is E.T.F., Or at Least That's the Theory," called leveraged ETFs "casinos on steroids." According to the article, after the ETFs make (or lose) money, they use options, swaps and index futures to rebalance their portfolios -- amplifying the day's gains and losses and wreaking havoc.

But wait -- high-frequency traders are big users of ETFs, so let's blame them again. Do you ever feel like we're going in circles? As we near the close of 2011, the same issues that plagued us at the end of last year are still haunting the securities markets. And we haven't made any progress toward determining whether HFT provides valuable liquidity or toxic flow.

A Broad Stroke

When I talk to sell-side traders about HFT, the responses typically are ambiguous. Yes, institutions are concerned, but no more than they would be about interacting with any other counterparty. No one seems willing to paint HFT as evil. In fact, sources at sell side firms seem almost cautious when discussing HFT.

Jamie Selway, head of liquidity management at ITG, characterizes HFT as "frenetic" and calls it the evolution of electronic market making. "It's liquidity providing," he says. Given its short-term nature, "It's loosely helpful," Selway notes. "You just don't want to interact with it in ways that betray a larger interest." But, he adds, this isn't that different from phoning a market maker in the past, when "you wouldn't want to betray too much of your larger interest."

Meanwhile, always concerned about leakage and gaming, institutional investors execute blocks of equities in dark pools, away from the public exchanges. "They always seem to be suspicious becuase what the buy side is doing is so information-sensitive," Selway comments.

But fearing another flash crash, global regulators, which are responsible for the market's stability, are prepared to act -- they are readying to "crack down" on computerized high-speed trading -- even though they're still not certain high-speed trading is causing the volatility. One idea coming from regulators on both sides of the Atlantic is to charge a transaction tax in order to slow down the machines and reassert the dominance of human traders. But an HFT tax may have unintended consequences, according to many prop traders.

One source with a proprietary trading firm tells me that a tax on HFT shops would erode their profit margins and cause a crash in volume. As a result, he says, "The bid-offer spread is going to widen out, which is going to end up costing the buy side more in transaction fees."

Since most market participants believe high-speed trading -- and volatility -- are here to stay, perhaps a better solution would be for regulators to sharpen their tools and better understand the patterns in electronic trading. "We really need the regulators to know what these behaviors are and to have the tools to police them," says ITG's Selway.