Robot traders good news for retail investors

Four questions about high-frequency traders to Björn Hagströmer, visiting research fellow at Swedish House of Finance and Associate Professor at Stockholm University.

How have stock markets been affected by the introduction of robot trading?

– Most studies show that overall market volatility and transaction costs have decreased due to high-frequency trading. This is good news, at least for retail investors. 

How much of the trading in the stock markets is now done by machines?

– It is important to note that there is no longer a clear-cut difference between human and robot investors. Virtually everyone is using algorithms for parts of their operation, even retail investors. What is significant about high-frequency traders, however, is that they have automated all parts of the decision process, from information retrieval, to analysis, investment decision, and finally implementation of a trade in the markets. The high-frequency traders profit by trading on small price differences that may exist only for a split-second, and above all by serving as electronic market makers. Their activities amount to about 25% of the total activity in the Swedish equity market.

When the market falls – how do the robot traders react?

– If the high-frequency traders believe that the decrease is a temporary setback they will act as a cushion in the market and mitigate the volatility. If they predict that the price fall is only the beginning, on the other hand, they may accelerate the fall by speculating in further price decreases. In one sense that can be good for market quality, because it implies that price discovery is accelerated and that the market is more efficient. However, fast price falls may also trigger panic among other investors, which could amplify the volatility.

What are the consequences for institutional investors of robot trading?

Though market quality in general has improved with the automatization of the trading process, the markets have also become more complex. This is not only due to fast trading, but also the fact that trading nowadays is fragmented across dozens of platforms. The complexity can work as a friction against human investors, who are unable to digest all price information in real time. In general, I believe that the increasing market complexity boosts the demand for sophisticated brokerage services. The effect on institutional investors, such as pensions funds, is largely unknown. I am currently starting a research project together with colleagues where we will investigate the long-term effects of market complexity on pension fund transaction costs.