What he apparently meant to say was that they reduce volatility, not create it. And this was just a slip of the tongue. As Sigmund Freud observed, such slips can reveal the reality.
I am concerned about High-frequency Trading (HFT) for two main reasons: Reduction of the relationship between value and price; Potential for positive feedback.
Markets exist to enable businesses to raise money, to expand, to thereby employ people, and so on, for the benefit of society. This only works if the market does a decent job of revealing the true value of a company via its share price. Otherwise the market is no different from a casino, a share price may as well be given by the spin of a roulette wheel. Fundamental analysis is supposed to do a similar job. You analyze a company, study its customers, research the management, etc., and come to a conclusion. But fundamental analysis is hard work.
Much easier is to run a data feed into a black box containing some algorithm, then optimize that algorithm. Your HFT black box doesn't care a hoot about the true value of a company, it only cares about what happens to the price over the next few seconds. You may spend a few months setting up this black box the first time, but thereafter you can apply it to a wide variety of markets with relatively little effort. Just re-optimize for that market. (And we know from how market players are compensated that the question of whether or not the result is long-term profitable is of second-order importance.) Not so with fundamental analysis, each market is different, each requiring the same weeks of hard work.
The above wouldn't matter if the HFT boys didn't dominate the market. Is it now 70% of trades on some exchanges are HFT trades?
Whenever you have a bandwagon, such as HFT now is, then you have the potential for systemic risk and feedback. Remember the last bandwagon…the credit products. How did that one turn out for the world economy?
To get feedback you need a quantity of traders following similar strategies.
"They all have different strategies," you say. Perhaps true for a while, but nor for long. Traders copy each other mercilessly, and since people in finance change jobs every two years it doesn’t take long for ideas to diffuse widely.
But feedback can be positive or negative.
Negative feedback is when an up move in a stock leads to a sell signal, and thus a fall in the price, and a down leads to a buy, and thus a rise in the price. This dampens volatility.
Positive feedback is when an up begets a buy, which causes the stock to rise again, causing another buy, etc. etc. And when a fall begets a sell, causing another fall, and further selling, and…
So which is it? Does HFT result in a reduction of volatility via negative feedback or an increase via positive feedback? This is an easy one. If you are a hedge fund manager which of the following would you prefer? A or B?
A. Low volatility. Shares go up or go down fairly predictably. No skill is required to make money, even by the man on the street. Hedge funds can’t charge large fees.
B. High volatility. Very difficult markets, experts needed and can charge large fees. If a fund does well they make a killing because of the enormous profit they have made for their clients. But they are just as likely to lose all their clients' money, in which case…nothing bad happens to the fund manager.
Yes, we are in that familiar territory of moral hazard. Of course the funds want to increase volatility and they have found themselves in exactly the place they want to be to make this happen.
(BTW If you want the mathematics of feedback see PWOQF2 or read the paper The feedback effect of hedging in illiquid markets, (P.Schoenbucher and P.Wilmott.) SIAM J. Appl. Math. 61 232-272 (2000). It's all about the gamma of a strategy.)
How did we find ourselves in this place? Because the HFT boys cleverly played the "liquidity card" at the right time. The argument goes along these lines: "When Mom and Pop want to sell off some of their portfolio to fund their retirement then they'll get a better price if there's more liquidity. So liquidity is good." True! For the shares they've held onto for 20 years they will indeed get an extra cent. Whoohoo! Break out the champagne! So you mustn't argue with the liquidity card. The more the merrier, right? Well, no. The fact that during those 20 years their shares have lost 50% of their value thanks to the Great HFT Crash doesn't ever get mentioned. One extra cent versus a 50% fall? Hmmm.
Everything in moderation. The more liquidity there is, the more you rely on its providers, and the worse the collapse when that liquidity dries up. And who is in the position to both cause this drying up, and to benefit from it? Why, it's the HFT boys again!