What Investors Should Know About Fintech, High-Frequency Trading and Flash Crashes

#Liquidity #Crisis Looming

This time on the Financial Sense Big Picture, Jim Puplava discusses why he thinks disappearing liquidity could be the next big unseen factor to kick off a crisis. There are three large forces precipitating this coming crisis, he noted: high-frequency trading, the ETF and passive index fund fad, and government regulation.

Liquidity Is the New Leverage

Liquidity could become a serious problem for basic market operations, Puplava noted, and high-frequency trading is the match that could start the fire.

Whenever we head into a bear market, Puplava noted, there’s always one factor that nobody sees coming. As Goldman Sachs recently warned, “liquidity is the new leverage if we head into another downturn.”

On a daily basis, almost 90 percent of trading on exchanges is carried out through high-frequency trading and index investing, Puplava noted. In the words of recent FS Insider guest Don Coxe, markets are no longer driven by humans but by machines, and machines know the price of everything but the value of nothing.

In the event of a major macro event – or worse, a monetary event – we could see markets move down rapidly, such as happened during the Flash Crash and also the Taper Tantrum. A minor correction is magnified because as HFT enters the picture, bids happen in nanoseconds and HFT traders withdraw liquidity from the market.

Additionally, it isn’t just equities that will be impacted. Bond markets, commodities, currencies, and more are now bought and sold largely through HFT. As these split-second trades go bidless, reducing the price at which someone steps in, it can drive markets down in the blink of an eye.

“Machines – and not humans – are making trading decisions,” Puplava said. “Humans have the ability to process complex macro information… The result is, we’re seeing more instances where this occurs in this decade as the machines take over the market… This feedback loop kicks in as investors interpret this price decline as confirmation that there must be news out there that’s really bad.”

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