High frequency trading
This morning there was an article in the New York Times describing high frequency traders- what they do and how they want people to like them. I’m of the mind that there’s not much to like.
NOTE: Please see update!
High frequency traders are basic, old-fashioned opportunists. They buy somewhere and try to sell somewhere else cheaper. They have expensive technology and colocate next to exchanges to deal with speed-of-light issues to shave off tiny fractions of seconds for their trades. They notice a currency change in Brazil and trade on it in the US before anyone else notices. That kind of thing.
They will tell you that they are useful to the market, because they have set the bid-ask spread smaller than it used to be. Back in the day, there were official “market makers” who would maintain a book of certain instruments, and would be the go-to person for anyone who wanted to buy or sell. In return for the service they would charge a fee, which would be this so-called spread. Moreover, they were required to offer to buy and to sell in all kinds of trading environments (the spreads could get pretty wide of course).
It’s true that those spreads have gotten smaller since high-frequency traders have come to dominate. They have substantially replaced the old-school market makers and claim to be doing a better job. However, it’s also true that high-frequency traders aren’t required to be there. So when the going gets tough they completely vanish. This happens in moments of panic, and it can easily be true that their ability to vanish at will can also create more panics more often (I’d love some evidence to support or deny this theory), since from their perspective, at the first sign of weirdness, they may as well pull out until the dust settles.
The analogy I like to come up with is a little story about chores. Suppose you have someone who comes and helps you with your cleaning, mostly dishes, every day, for a small fee. Since you have kids and a job, the small fee seems to be worth it. After a while someone else comes along and offers to do your dishes every day! for free!! What a deal! You can’t resist. However, it turns out that, if the kitchen actually gets really dirty and needs to be mopped up or seriously cleaned, the free-dishes guy is nowhere to be found and you’re on your own, just when all the kids are sick and there’s a product release at work. Maybe not such a great deal after all.