This is part of an ongoing series describing silver “Electronic Price Discovery versus the Fundamental Reality”.
In this discussion, we will go a little deeper and narrow with HFT and algorithm trading, and more specifically its impact on the market.
First off, I don’t think that speed, electronics or computers are necessarily a bad thing in and of themselves. Nor are the tactics employed, including “sub-millisecond trading” or “co-location of servers”, the latter meaning one can physically place servers closer to the exchanges and therefore gain a speed advantage. I don’t think they’re necessarily bad things in and of themselves.
The problem, and what has evolved over time, is the relationship between speed, electronics and computers, and the ‘de-evolution’ of non-profit exchanges into for-profit exchanges that are also ‘self-regulated’. This is the absurdity. The CME, the Chicago Mercantile Exchange which owns the COMEX, is one of these for profit exchanges. They give direct advantage to the big traders, big players. COMEX is the prime determinant of world silver prices.
For-profit exchanges allow large traders to literally buy access or speed. They get special access to trade ‘order flow’, or the ability to see the market order landscape before trades are actually executed. They also have the ability to get momentum rolling with what’s called momentum ignition or spoofing. They have the ability to positions or trades on the market, effectively putting the price wherever they want it, just before pulling back, and not ever actually filling those trades. However the price has been set just long enough for other algorithms to see them. From that point the volume comes pouring in and the outside it appears that the market was merely reacting to outside conditions.
The result of this for-profit enabled trading phenomenon is what we call HFT – or high frequency trading. High frequency trading or high frequency traders they use algorithms to trade. Again, algorithm is another word that I don’t think is a really bad word in and of itself. However, the unfair advantage given to the preferred clients leads to a massive, and ultimately unsustainable price distortion.
When you see the price drop in the middle of the night or at 5am in the morning, usually it’s a big bank, otherwise known as a commercial trader on the COMEX that has set the price point, inducing the volume come in behind it.
When the price drops, the managed money traders go short because the HFTs got the ball rolling. The reverse happens on the upside.
Of all the artificial factors that influence paper or electronic pricing, HFT is the most important because it occurs on the futures market. You can witness the evidence of this in retrospect by quickly analyzing the Commitments of Traders Reports, where the relative change in positions for each category is displayed publicly.
HFT comes from a benign lineage. It comes from the evolution of speed, computers and electronics in price discovery. As regulatory capture eclipsed all hope for enforcement, this class of trader replaced the market makers of old, to become evermore powerful across all market classes.
My hope is that when you see these 4 or 5% drops out of nowhere, with no news, no change in overall supply and demand, and that you remember it has nothing to do with fundamentals. Instead of immediately going around and looking for some other reason why, that you stay focused on where we are in terms of how price is influenced by these top factors.
And it should also be painfully clear that there is no way for the average investor to trade around these moves fast enough.
Of course, this is not sustainable. We see evidence of that in equities trading. Two massive flash crashes in the past six years were unmistakable. HFT’s feed from volume and liquidity. During these flash crashes, volume dries up suddenly, leaving these massive HFT algorithms trading among themselves – selling into a vacuum.
In a system already fragile a large enough flash crash can cause irreparable damage and destruction rippling out across the macro-financial landscape.
At that point, real supply and demand fundamentals will be laid bare for all to see.