NEW YORK (TheStreet) -- It's clear enough that high-frequency trading affects professional traders and sophisticated market participants by obfuscating order flows and increasing short-term price instability.
We wrote an article geared toward the active trader last year and look at a different side of the story in this one.
Though the discussion about high-frequency trading is old news in the financial world, Michael Lewis' new book, Flash Boys: A Wall Street Revolt, has brought the discussion into the public eye over the last few days.
The broader and different audience now exposed to the issue demands we ask broader and different kinds of questions: How does high-frequency trading really affect individual investors and what is its macroeconomic impact?
We identify at least four ways that high-frequency trading affects investors and the economy.
1. Erodes Investor Confidence
Lewis' book portrays high-frequency traders as ruthless financial predators operating on the fringes of the law. Their activities, illegal in the spirit if not the letter of the law, are obscured within the microsecond gaps beyond regulators' reach, stealthily separating investors from their money a few pennies at a time.
The narrative is hyperbolic, but it's hard to argue with the fundamental point: the traders do seem to engage in practices that look very much like front-running, the computer systems used in high-frequency trading probe the markets using techniques that are, at the very least, rather gamey. The very heart of the systems' competitive advantage is their ability to exploit market information a fraction of a second before it becomes widely available in violation of the spirit of the law.
Even if you disagree entirely, the perception of impropriety and reduced transparency is itself a reason to worry. Because high-frequency trading now comprises a large portion of trading volume on major exchanges, anyone who that doesn't trust it also doesn't trust the exchanges.
The inherent opacity of an operation that floods the markets with millions of convoluted orders per second makes it ripe for abuse, and necessarily breeds mistrust. Because investor confidence affects macroeconomic behavior in profound ways, a widespread belief -- whether founded or not -- that abuses are occurring is a massive problem in and of itself.
2. Increases Cost of Capital
A 2012 analysis by Credit Suisse shows that "real" U.S. equity volume -- that is, not high-frequency trading -- may have hit its lowest point since 1999.
The inflated volume the high-speed traders generate doesn't reflect a genuine demand for equities and doesn't make up for the loss of real investor activity.
While the drop in real volume is not entirely related to high-frequency trading, it's hard to imagine that it doesn't play at least some role. After the experience of the IPOs of Facebook (FB) - Get Report and BATS Global Markets (BATS) , companies looking to raise money and their investors are right to be worried about exchanges.
So should anyone, other than traders, worry when exchange volumes drop? Yes, the effects are broad and affect the economy at large. When investors are hesitant to put money into the stock market, the lower demand for equities drives up the cost of raising capital and slows down investment activity overall.
3. Exposes investors to Big Risks
It's common for analysts, even those critical of high-freqency trading, to shrug off its impact on the retail investor. After all, if you trade at most a few times a year and mostly hold stocks for years, why should you worry about a sub-minute flash crash?
While it's true that most retail investors will never directly experience the effects of the flash crashes that high-frequency trading induce, even they are far from immune.
To begin with, many small investors include price stops as part of their risk-mitigation strategy. In the past, you might have placed a stop on your Apple (AAPL) - Get Report stock 10% below its current price, and felt secure that you had a prudent safeguard in place. Not so after the flash crash of 2012 when, if you had had such a stop in place, you would have been robbed of your 10% within several minutes for no underlying reason at all.
Even if you don't use these kind of long-term stops (you shouldn't), a portion of your wealth (e.g. a retirement savings) is likely in a fund that is interconnected with investment vehicles that may be sensitive to short-term declines.
The fact that high-frequency trading hasn't yet directly caused any events that wiped out a large number of investors' wealth is no reason to pretend that it can't. It would take an unusual set of circumstances, but the risk is there. And the system's built-in obscurity makes that risks all but impossible to quantify, which is perhaps the most worrying part.
4. Passes increased cost of hedging onto consumers.
When a farmer plants corn, he doesn't put his financial future at the mercy of the commodities markets. He insures himself by purchasing corn futures, thereby guaranteeing that he can sell his product at a price point that protects his operation.
Futures contracts are just as prone to price instability induced by high-frequency trading as are equities are, and the increased short-term volatility is priced in. One way or the other, the farmer pays for a portion of the risk and, one way or the other, a portion of that premium is passed onto you at the grocery store.
As the public becomes more exposed to what high-frequency does, it seems increasingly likely that outcry will lead to action. Regulators may step in once the realization crystallizes that high-frequency poses systemic risks, but in the meantime, we expect the exchanges themselves to take action first.
If exchanges such as the New York Stock Exchange and Nasdaq are to remain competitive in the face of emerging players such as IEX, they need to regain market participants' trust and rethink their (admittedly lucrative) relationships with high-frequency-trading firms. If they don't, investors may well start voting with their wallets.
At the time of publication, the author had no position in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.
About the authors:
Victor has a background in math and computer science, and for the past twelve years has been an independent investor and proprietary trader. Victor specializes in fundamental and statistical analysis of event-driven and special situation strategies.