Last Updated: 3 June 2023
Proponents of high-speed trading say it provides liquidity, thereby reducing transaction costs for investors of all stripes.
Let’s hope so. Such trades make up about half of all equity trades on US exchanges.
What’s troubling isn’t so much the speed of these trades, but the cancellation rate, which is a staggering 98 percent.
Maybe someone can explain to me how a trading system where virtually all the orders are cancelled helps capital markets or investors. Key liquidity measures like bid/ask spreads and depth of book depend on order information. With high-speed trading, almost all of that information is false.
In short, it seems to me that high-speed trading promises liquidity, but delivers something else entirely: market manipulation.
Wednesday’s Wall Street Journal cites a particular order type that highlights this point. With “Hide Not Slide” orders, the true price is concealed while a false price is displayed until someone tries to hit it.
It’s the classic bait-and-switch: an investor looks at the order book, sees reasonable depth and places a market order only to get executed at a price that is essentially invisible.
This practice isn’t illegal. On the contrary, it’s increasingly systematised and hard-wired.
So what does all this have to do with ETFs? Everything.
The typical ETF holds a basket of stocks. And the price of that ETF—published every 15 seconds—reflects the intraday market price of its underlying securities.
This structure makes ETFs inherently sensitive to intraday moves in the underlying basket, since changes in any one stock in the portfolio will affect the ETF too.
I’m all for prices that reflect the market’s consensus about the most current information on a company. Price momentum has a role to play too, at least in the short term.
But price discovery in a flood of phony orders can only distort accurate valuation.
This far-from-ideal environment comes about when high-frequency trading operates as designed. But things get even worse when the system breaks down.
We saw such spectacular failure in the 2010 “flash crash,” and more recently, in huge, though fleeting, price drops in Apple Computer the day the BATS Exchange’s initial public offering was derailed.
Mutual funds don’t face any threat from intraday swings. And while I prefer ETFs to mutual funds in most cases, I can’t blame investors who want reduced exposure to intraday shenanigans produced by high-speed trading.
It’s time the US$1.21 trillion US ETF industry recognised and addressed this threat to its well-being.