For many, the idea of hearing the words “stock market” make them freeze. It sounds boring and a lot to do with money and numbers. Or alternatively it brings to mind images of Leonardo Di Caprio in Wolf of Wall Street explaining confusing schemes while the audience sits in anticipation for his next Quaalude binge.
This may all seem boring but the stock market does affect everyone. The a common example is that of the Great Depression which came about, in part, as a result of the collapse of the stock market in the 1920s. While this is a simplification, it can prove the devastation that these monies and numbers can have.
Since the 1920s a lot has changed, firstly stocks aren’t traded the same way they were in the past. Now rather than having a whole bunch of people screaming at each other in a pit, trading happens through servers. Trading stocks is no longer solely about money but rather also about time. This is because of the rise of high-frequency trading.
Quick stock market 101
The stock market is where shares in companies are traded to the public. These shares are bought and sold every day at prices which move according to the percievied value of the shares. Buying a stock means that you have a small share in that company. The company then pays you a dividend for investing in them.
These shares are bought and sold at certain prices which are always changing depednign o nthe percieved value of the company. People then use this to make a profit by selling their shares that have subsequently gone up in value.
There are more complicated scenarios that play out but this is the simple background to the way the stock market works.
Each country has its own stock markets with the most well-known being the DOW Jones and NASDAQ based in the U.S. South Africa’s main stock exchange is the Johannesburg Stock Exchange (JSE).
What is high-frequency trading?
Since computers and network lines are getting faster, a new way of trading has been opened up. This has been called high-frequency trading (HFT).
A paper on HFT by the World Federation of Exchanges (WFE) states that, “HFT is not a strategy but a technology which many financial firms are embracing around the world”
HFT is a trading platform which uses complex algorithms to analyse markets and makes trades in shares based on those market conditions at very high speeds. The system is based on looking for price differences based on differences of micro and even nanoseconds.
It was explained that countries have multiple stock exchanges through which trader buy and sell stock. These HFT traders and their algorithms look for price differences in the stocks traded on different markets in order to take advantage of it and sell stocks at a profit.
HFT’s have grown significantly in world markets. The WFE paper explains that in 2012 HFT trades were estimated to make up 51% of equity trades in the U.S.
Cool so we’re trading faster, so what?
This new way of trading has its benefits especially for the traders. Through the utilisation of the fastest network connections and proximity to various exchanges, it is possible to make significant profits.
It also has had other benefits such as introducing more liquidity (the degree to which a stock can be quickly bought or sold without affecting the asset’s price) to the market, reduced transaction costs and lower market volatility in most circumstances- to name a few.
HFT also created an unfair advantage to traders who used these algorithms as they would see the trades before others. Many exchanges have already put in place regulations to make the markets more transparent and fairer for all traders.
While regulations determining fairness have come about, other issues regarding volatile price jumps as a result of dumping shares into the market have not been as specific. These kinds of events are still of concern since they can have unwanted outcomes. One of these outcomes is a flash crash.
What is a flash crash?
A flash crash is when the value of shares drops incredibly quickly but for a short period of time. While significant stock market crashes such as that of the 1929 happened over a few days and took months to recover from, the flash crash in the U.S stock markets in 2010 only lasted 30 min.
While the quick recovery may make it seem as though such a crash is not as important as one that can last months, such unexpected dives can cause problems with shareholder trust as they undermine the concept of the value of a company.
Although this crash has since been explained to be as a result of multiple causes, the high-frequency traders did play a significant role.
“High-frequency traders …stopped trading, while others immediately sold whatever they bought, mainly to each other, in what has been called ‘hot potato’ trading,” explains former US Senator Ted Kaufman in a recent article for Fortune.
There is still a fear that without proper regulations such crashes will happen again.
South Africa and HFT
While the focus of the concerns around HFT sit significantly on the US exchanges and traders, South Africa has made significant improvements in using and dealing with HFT.
The JSE made its move in the beginning of 2012 to HFT. In 2014 JSE CEO Nicky Newton-King told Business Day Live that a fifth of its equity activity came from HFT’s.
In addition, the JSE have implemented initiatives which look to ensure that HFT works well and efficiently in South Africa.
“Going forward, the JSE will continue to monitor global legislation in order to introduce relevant local innovations where necessary” stated an article written by the JSE.
Econoblog 