Whether it be the resignation of a CEO, an unexpected statement from an influencer, or a company’s returns, a recent piece of news often explains why a stock is skyrocketing or plummeting on a particular day. Indeed, one of the most essential non-economic steps that an investor can pursue to start seeing financial gains is to constantly be refreshing their news feed.
It’s logical: The stock market is inseparable from the never-ending flow of entrepreneurial and executive announcements happening around the world. After all, investing in the market means buying a portion of a company or a currency which dictates some part of society. How much room does this leave for politicians to influence and address the inequalities of the stock market? If private companies, hedge fund managers, CEOs, and outspoken critics influence the market so much, do politicians have the capacity to introduce incremental change to the way we invest?
We have previously explored the momentous role which regulators can play by facilitating the development of exchanges that discourage the dominance of special interest on the market. The Chicago Stock Exchange joined IEX and other emerging exchanges to impose its own version of a 350-millisecond delay to impede High-Frequency Traders from convulsing the market. Politicians, however, have a less direct role in implementing reform. The best a politician or an activist can usually do is leave an acute, short-term impact on a stock which will subside over time. Regulators and new exchanges are the only entities that can propose significant changes like adding a delay to prevent HFT, and even then they are often constricted by the special interest which oversees the market.
One individual in the political sphere who plays a major, though indirect, role in the economy is the president since he nominates the Chair of the Federal Reserve. The Fed monitors the United States’ banks, interest rates, and monetary policy among other things.
The problem is that appointing a new Chair of the Fed does not necessarily translate to long-term reform on the stock market. Even the Fed’s announcements and target interest rates have superfluous, transient effects on the market. For example, it might seem like the Fed’s involvement with declaring and targeting interest rates have a monumental impact on stock prices. If interest rates fall, a business can borrow money more easily and customers are more inclined to spend their savings, which would lead to the rise of that company’s stock price. Unfortunately, it isn’t so simple. Dimensional Fund Advisors, a private investment firm, studied how stock returns and bond yields changed over a 62 year period and found no correlation between the two variables. In short, interest prices, one of the principal responsibilities of the Fed, is not a major factor that influences investors’ behavior.
Politicians do not govern the long-term trajectory of certain stocks. Earnings and growth drive a stock’s success in the long run, and investors are tasked with remaining informed about particular companies to make the best possible choices. What politicians should be concerned about are crashes. Most of the time, “HFT provides liquidity and reduces stock volatility. But during unusual times, such as big news days or stock market crashes, HFT could increase volatility,” explained Professor Frank Zhang from the Yale School of Management. “Normal days of low volatility may give ordinary traders [a] false impression and promote them to take more risk[s]. They could lose a lot during bad times as volatility is higher with HFT.”
Volatility is the key problem that politicians should be eyeing when seeking to reshape novel practices like HFT. U.S. officials and members of the Fed have already questioned and criticized the risks which HFT carries for economic crashes, but politicians need to go one step further and actively predict when these crises will occur. Higher amounts of trading volume tend to increase the chance of destabilizing volatility, and, according to research by the UK Government’s Foresight Project, there even seems “to be an inflection point at which an increase in trading volume increases volatility to the extent that only a small circle of investors benefit.” The market is controlled, in part, by individuals with access to high-speed technologies because they cause volatility.
Nanex, a firm which provides real-time analysis of ongoing financial activities, produced a report of the May 2010 flash crash which is largely attributed to HFT’s disruptive changes to buying and selling on the market. Proponents of HFT claim that they are increasing liquidity, engendering robust stability. Liquidity refers to the ease with which an asset can be converted to cash without affecting its price. For example, if someone owns 100 shares of a stock on the market and an investor wants to buy 110 shares, the price of the stock will rise because the demand is clearly higher than the supply. However, if the investor just wants to buy 100 shares, he or she can do so without the price changing. This transaction provides liquidity to the market because the asset’s price was not affected.
High-Frequency Traders usually make the claim that they are adding liquidity to the market because they oversee an immense number of transactions. If a computer can execute hundreds of thousands of orders for a particular stock without the price changing on a regular basis, the liquidity remains relatively stable. Unfortunately, this doesn’t work forever. The balance can shatter in an instant when orders become overwhelming.
When investors seek to buy stocks on the market, there is usually a bid-ask spread, the difference between the highest and lowest price that the investor seeks to buy the asset. When High-Frequency Traders make orders, they generate enormous amounts of these spreads since so many are being transferred at the same time. The result is that small flash crashes can turn into colossal crises—HFT spammed the market with so many spreads that it is estimated that the Securities and Exchange Commission (SEC) took five months to compile the data about all of the orders preceding the May 2010 flash crash.
Two solutions need to be pursued to prevent such crashes. The first must be taken by regulators like the SEC. They should allow, and even encourage, exchanges to impose delays that make it difficult for HFT to upend the stability of the market. They are the ones responsible for short-term changes that can mitigate the risky flash crashes that HFT entails.
The second solution is the one that politicians must prioritize. Bipartisan efforts should focus on the long-term economic measures that predict and prevent bubbles and devastating crashes from developing. The International Monetary Fund issued a report on the symptoms that presage crashes on the market. Some patterns at a worldwide level are that “international reserves may become dangerously low, or the level of external debt commitments become too high relative to the economy as a whole. Alternatively, movements in asset prices may follow a common pattern in anticipation of currency crises.” HFT must be scrutinized routinely by politicians to predict an upcoming crisis. If an enormous number of High-Frequency Traders suddenly begin buying one particular asset, for example, this should be a warning sign to observant politicians. It would not be too onerous to track these patterns since HFT now represents about half of all trading volume in the U.S.
In addition to paying close attention to the behavior of High-Frequency Traders, politicians must coordinate bipartisan, large-scale responses to economic crises in order to properly recover and diminish the harm that comes from the next one. The inability of GOP lawmakers to strike a deal with Obama over his $4 trillion debt reduction bill after the 2008 financial crisis prolonged the instability for years afterward. Crises will be less destructive if politicians from both sides of the aisle are able to properly reconcile their differences after a crash and enact legislation that specifically reinforces our ability to respond to alarming signals in the market. While politicians do not play a direct role in the stock market, they can certainly help reduce its volatility, a key step towards protecting the many investors who have invested their savings in recent years.