During an appearance on CNBC yesterday, Charlie Munger, deputy to billionaire investor Warren Buffett, had some harsh words for high-frequency trading, the practice used by huge financial firms to trade stocks in milliseconds. “Take the rapid trading by the computer geniuses with the computer algorithms,” said Munger. “Those people have all the social utility of a bunch of rats admitted to a granary.”
As a new report from Demos makes clear, high-frequency trading definitely is the equivalent of admitting rats to a granary, as it extracts value for traders but without bolstering investment. The price of that is ultimately paid by consumers:
The increasing inefficiency of the Capital Intermediation process is in part attributable to the trading practices of [high-frequency traders] HFTs, which generate high trading volume and no investment. The cost to the system is generated by several factors. First, the illusion of market liquidity provided by HFT volume leads to the inherent instability of market pricing mechanisms. In addition, aggressive HFT tactics mislead market participants in terms fundamental price. Finally, Dark Pools, trading venues that exist because of HFTs, impair price discovery.
All of these distortions extract value for the HFTs. Investors pay the cost initially because their investments are less valuable in conditions of chronic price distortion. However, investors must compensate for the additional cost that results from the extracted value by adjustment of price. This price adjustment is paid for by the consumers of capital.
High-speed trading now makes up more than half of the stock market’s volume. As this chart from the research firm Nanex shows, high-frequency trading has exploded since 2007, spiking in the aftermath of the Great Recession:
The Securities and Exchange Commission voted yesterday to draft new rules to rein in high-frequency trading. Doing so would both drive investment to productive sectors of the economy while removing dangerous volatility from the market like that which caused 2010′s “flash crash.”