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Can High-Frequency Trading Drive the Stock Market Off a Cliff?

June 18, 2013 | Wei Pan, Alex Sandy Pentland, Ren Cheng, Lisa Emsbo-Mattingly | Strategy

Much of the time, high-frequency trading firms play a benign role in financial markets. These firms use fully automated computer systems to buy and sell stocks very rapidly, making thin profits by being ahead of human orders. But in a nervous market with downward price pressure, high-frequency trading can create fierce volatility.

The authors conducted a computer simulation of high-frequency trading behavior, gaining new insights into the role of high-frequency trading in events like the 2010 “flash crash,” when U.S. stock market indices suffered a sudden drop of 9%, evaporating over one trillion dollars within 30 minutes.

When the authors ran the model assuming that real investors were trading randomly, with half buying and half selling, good things happened. “Under a simulation with such circumstances, high-frequency trading firms did not influence the market price much and in fact made the market smoother and less volatile,” the authors write.

But when they ran the model simulating a market with more nervous market participants and strong downward pressure as people were trying to get out of the market, the market was stable for a while and then, suddenly, crashed. “Without the high-frequency trading firms, the market would decline in a more manageable and gradual fashion,” the authors write.

“The lesson for those managing complex systems is to be extremely cautious about those systems' behavior: They will often react in ways that are surprising,” write the authors. “It may turn into an unfamiliar monster when an invisible tipping point is passed.” And because these extreme phases may be rare, they are not well studied and not always factored into decision making.

The authors also advocate that the synchronization of high-frequency trading firms be monitored, “and high-frequency trading orders should be automatically paused when synchronization levels hit a threshold, such as three standard deviations above normal activities.”

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