The new generation of derivatives, developed during the 1990s, were once the pride and joy of financial innovators. The global financial crisis left their reputation in tatters. They are now seen for what they are—casino chips used to encourage unwary speculators to bet on overinflated assets.
Thankfully, economists are coming out of the woodwork and challenging the paradigm that all financial innovations are worthwhile.
In an article titled “What Do Banks Do?”, Lord Adair Turner, chairman of Britain’s top financial watchdog, the Financial Services Authority, attacked Wall Street and other financial centers claiming that they were mainly engaged in “socially useless activity”. He went on to say that “financial innovation … may in some ways and under some circumstances foster value creation, but that needs to be illustrated at the level of specific effects: it cannot be asserted a priori”. Needless to say, Turner’s comments caused an uproar and he came under attack.
Paul Volker, the former Federal Reserve chairman, also questioned financial engineering. “The economic and social value of much of the trading and innovative financial engineering is questionable”. He went on to explain that the global financial crisis was triggered, in no small part by complicated trading activities.
In the face of banking behemoths whisking trillions of dollars around the globe with the click of a mouse, it is all too easy to forget that the banking system’s social purpose is to channel savings into productive investments. When a depositor places money into a savings account, the bank is supposed to lend it out to corporations, small businesses, and families looking for capital to invest in plant and equipment so that they can engage in commerce. In return, the bank charges an interest rate which covers its services as well as providing income to the investor who provided the money in the first place.
The latest innovation introduced by banks uses high-frequency trading. Using computers, algorithms automatically trade shares at astonishing speeds. In the quarter of a second it takes you to blink, a high-frequency trading computer can carry out over 5,000 transactions.
These algorithms search out stocks that are rising, to cash in on the upward trend. Other algorithms take advantage of infinitesimal price variations between the same stock on two different markets; buying low in one and selling high in the other.
According to a former banker, “It’s become a technological race for traders trying to exploit quirks in human behaviour. So what’s at a premium is the timing and getting hold of the data as quickly as possible.”
In the US, computers have largely taken the place of human traders and account for 70 percent of total trades. Used by large brokers and hedge funds, these computers buy and sell shares in milliseconds. Large profits are made as a result of minuscule movements in share price, as trade volumes are in the billions of dollars.
To make matters worse, high-frequency traders are often provided with privileged access to information a split-second before it is provided to everyone else. It only takes a millisecond to execute trades and take advantage of the information which gives it the features of insider trading. While unethical, it is technically legal.
Frequency trading is not only unfair and undermines the integrity of markets, but it runs counter to the whole point of banking, which is to channel capital into productive enterprises. At its heart, it represents nothing less than naked speculation.
As we saw in the run-up to the global financial crisis, bankers lost sight of their social purpose and became high-stakes players in the financial casino. Just as many types of exotic derivatives undermine the connection between the real economy and financial services, high-frequency trading has opened up new opportunities for bankers to make obscene profits.
Moreover, this particular financial innovation distorts markets by focusing on short-term returns. Little wonder that banks are now making large profits, yet are doing little to pump money into the real economy. The result is a sterile recovery which produces few or no jobs.
Former high-speed trader at Citadel Investment Group and Allston Trading, Dave Lauer, told the US Senate Banking Committee in September that the complexity of high-speed trades had reached such a level that the market was becoming extremely fragile and at risk of devastating crashes. He warned that high-speed technology was “a destructive force in the market” with “no social benefit.” We are truly in a crisis,” Lauer added.
A practical solution to this problem was suggested by Martin Hutchinson, Global Investing Strategist with Money Morning, who advocates a small tax, perhaps 0.01%, on every transaction. He goes on to explain that “apart from raising revenue, its main effect would be to inhibit speculation. By that I specifically mean “high-frequency trading,” … where computers trade bonds, stocks, and derivatives in milliseconds.” This would also generate revenue, which could help governments weather the next financial downturn.
A more radical solution is to ban high-frequency trading altogether. This approach is supported by Robert Talbut, chief investment officer of Royal London Asset Management. “I see [the] role of financial markets as matching up providers of capital with users of capital. I see HFT as absolutely nothing to do with investment. It is trading for tradings sake. It has no interest in a company’s fundamentals. Therefore I fail to see why it’s an activity we should be encouraging to be part of our market”.
We can’t afford to have a financial system built on super-fast computers that place private gain ahead of public interest. Governments need to cooperate in order to reform international financial markets so that they return to their original purpose—that is, facilitating capital allocation and rewarding good judgement.