The Risks Posed by High-Frequency Trading

As reported by the Economist, faster is not always better. Who would want a doctor’s appointment that lasted 30 seconds or a whisky that had been matured for a week? But when it comes to the stockmarket, the acceleration of high-frequency trading (HFT) seems unstoppable. Trades on NASDAQ can be made in 250 microseconds, or one four-thousandth of a second.

Liquidity is assumed to be good for capital markets. If investors know it is easy to sell their holdings, they will be more willing to buy. This will lead to a lower cost of capital for business and thus more investment in the economy. HFT, which accounts for two-thirds to three-quarters of all Wall Street volume, seems to have led to smaller spreads (the gap between bid and offer prices).

But the stockmarket is also supposed to be concerned with the efficient allocation of capital. Companies with the best growth prospects should find it easiest to raise money. That needs a more considered analysis of corporate prospects than can be achieved in under a second. The average holding period for shares traded on the New York Stock Exchange has fallen to four months. Whereas Warren Buffett searches for companies with a sustainable franchise that trade below their intrinsic value, HFT might as well be buying and selling baked beans.

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