Several weeks have passed since the Dow Jones Industrial Average plummeted nearly 1,000 points with little explanation, leading well-known companies to trade at a fraction of their normal prices. These kinds of seemingly unexplained fluctuations have become more and more common in the last decade, and among the ones being blamed are high-frequency traders who use powerful computers to pick up and exploit small variations in prices. This can mean substantial profits as automated programs in these computers issue orders every millionth of a second.
If a million such orders were to be placed with no human intervention, there would always be the risk of these falling foul of mechanical errors or acting in ways contrary to common sense. This is not unlikely if there are bugs in the programs that run these computers. Given that these computers now control over 60% of trades in some major exchanges, errors on their part can have consequences for others in the market. We saw that vividly when shares of established companies such as Accenture and Proctor and Gamble dropped steeply despite no change in their fundamentals.
One of the financial mega-trends of the last 30 years has been the general decline in interest rates offered by banks as part of a tendency among governments to induct smaller investors into equity markets. It is believed that markets do the best job of allocating resources and there is a strong correlation between growth and the size of equity markets as a proportion of the gross domestic product. In the US, in particular, and in India to a much lesser extent, large absolute amounts of individual savings are now captured in the stock market. It is, therefore, important that reason and predictability prevail in these markets.
This is not to say that risks should be taken out of the markets, but uncertainties wholly unrelated to the creation of a liquid market are perhaps better avoided.
This, however, has not happened. The permissive nature of US financial regulation has meant that high-speed trading has taken a major share of the equity market volume. Yet, even its most ardent fans do not deny that high-speed trading only adds a frenetic level of volatility to what is already a very liquid market. It does not achieve any material change in liquidity.
Despite more than a month of intense examination, neither the Securities and Exchange Commission (SEC) nor the New York Stock Exchange (NYSE) has been able to trace the origin of the rogue trades that caused the 6 May drop.
Given the losses suffered by institutions and private individuals during the financial crisis, one would hope that the less savoury aspects of market structure, such as high-speed trading, would be given short shrift.
Lord Paul Myners, former UK treasury minister and fund manager, had last year come out strongly against the risks of high-frequency trading. One hopes financial institutions will support similar moves by SEC chairman Mary Schapiro, US senator Chris Dodd and others to put a check on what is a meaningless innovation. Practices such as high-frequency trading must gradually be put to rest.
Retail investors are already worried about issues such as insider trading and the general tendency of financial institutions to generate over-optimistic or even misleading predictions while taking opposing positions themselves. They do not need yet another source of uncertainty that would place their savings at risk.
Govind Sankaranarayanan is chief financial officer, Tata Capital Ltd. He writes on issues related to governance
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