Guest Post: The HFT-Induced Extinction Of Retail Investors

Invasive behaviour and extinction in the retail market

The term "invasive species" has been used to describe new types of plants or animals that have been introduced to a new area, whereupon they change the local biosystem.

The sudden appearance of new lifeforms in an environment can cause rapid losses in some of the species present prior to this appearance. Biosystems are dynamic systems with considerable stability, and often the arrival of new species simply cause a slight change in the dynamics of the system, which continues on with only small cosmetic changes.

On occasion, however, the new players cause overwhelm the stabilizing factors in the system, which undergoes dramatic changes, eventually stabilizing in a new configuration that is highly detrimental to many of the original players in the system.

Which brings me to today's invasive species.

Although high-frequency trading has been around for nearly a decade, it didn't hit public consciousness until the "flash crash" of May 2010. In the past two years, the incidence of HFT flash crashes has expanded (see archive here [8]) to the point where they are causing significant pain to the retail investors.

Much has been written about the impact of HFT, and a broad survey of the literature is so contradictory that I have to feel that some authors are not writing honestly. For every article about manipulation and increased volatility and reduced liquidity, there are academic papers like this one [9] claiming that HFT "improves liquidity and enhances the informativeness of quotes".

Many of the characteristics of successful invasive species [10] are shared by HFT algorithms:

1) fast growth;

2) rapid reproduction;

3) the ability to alter form (mutate) to suit current conditions;

4) tolerance of a wide range of conditions (except perhaps transparency); and

5) ability to live off a wide variety of food types. As a bonus, living in contact with humans also helps invasive species.

What in the market is going extinct? The retail investor.

How so? It comes about through the erosion in their margins brought about by HFT. In the presence of HFT, the unsophisticated investor pays a higher price on the buy and receives a lower price on the sell than would be the case otherwise [11]. The professional traders manage to maintain their margins--the losses of the unsophisticated are the profits of the algos.

As our markets have come to resemble casinos, investment is increasingly like gambling. For a typical gambler in a casino, where winning is determined by chance, is eventually ruined [12]. Gambler's ruin is inevitable in a fair game--but comes faster now that the bias is negative because algos are skimming a little off each one of our gambler's bets.