The Dangers of High-Frequency Trading

Anat Admati tackles the tricky subject of high-frequency trading.

Jun 5, 2014 at 6:30PM

Anat Admati is a professor of finance and economics at Stanford University, but she is more widely known for her critically acclaimed book: The Bankers' New Clothes: What's Wrong With Banking and What to Do About It. Alongside her co-author, Martin Hellwig, Admati deconstructs the idea that a safer financial system is inherently damaging to economic growth and discusses the dangers of high-frequency trading.

In examining what makes a safer financial system, Admati tackles the tricky subject of high-frequency trading. The use of HFT strategies by hedge funds and certain trading desks within big banks has long been a presence on Wall Street, but many people are uncertain about how they turn a profit.

The first thing to understand is that HFT is not the same as investing. It's a method of buying and selling securities using sophisticated technology that is much, much faster than any computer used by regular investors. By focusing on speed as opposed to a company's underlying fundamentals, HFTs have carved out a niche for themselves. 

The second thing to keep in mind is that not all fluctuations in a stock price are trends. An uptick or downtick can simply be the product of a large order placed by a pension fund or mutual fund. When that happens, several HFTs will swoop in, battling to get there first. Whoever wins will buy some shares and sell (or short-sell) them as the price normalizes. Supporters of HFT claim it removes volatility from the market by making small arbitrage-like profits and pushing the stock price toward a fair price, but Admati disagrees. 

We do need [liquidity], but oftentimes the word is abused because a lot of the problems in [finance] are said to be plumbing problems, liquidity problems. So that part is just a convenient narrative to hide what's really wrong. ... We do not need, for the reasons that trading actually takes place at all, price discovery every nanosecond. No one is using that price to do anything useful for the economy in the next nanosecond that they could be prevented from doing. If we eliminated the illusion of continuous time trading and only traded every second. ... I think that would probably be a good thing.  

See the full video below. 

If you enjoyed the video, I recommend you read a review of her book by fellow Fool John Reeves, or watch Ms. Admati speak at a recent TEDx Conference.

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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