Module 2: Investment Basics | Blog 2-1: Overview of the Financial Markets by David S. Krause

800px-Flash_Crash 2.1

Flash Crash of 2010

In the first module of the course (Introduction to Applied Investing) and again in Lesson 2-1, a discussion of the functioning of the U.S. financial markets was conducted. It was also noted that public opinion about the ‘fairness and effectiveness’ of the securities market is disturbingly low at present time.

The low confidence in the financial markets is understandable. The “Flash Crash” which occurred on May 6, 2010, in which the Dow Jones Industrial Average fell more than 5% in a about 5 minutes and then rebounded, has never been adequately explained. Michael Lewis in Flash Boys also opened our eyes to the potential system-wide risks of high frequency trading.

On March 23, 2012, the third largest securities exchange in the U.S., BATS, withdrew its IPO after technical issues derailed its trading. Then two months later, on May 18, 2012, technical issues marred the Facebook IPO – and finally on August 1, 2012, a technology issue at Knight Capital Group resulted in massive losses of over $400 million in less than 30 minutes.

Partly as a result of these technology-related market failures, many investors, practitioners, and regulators remain concerned about the complexity of today’s market structures, This concern seems to be focused on the impact of high frequency trading on the markets; however, a major study released recently underscores the health and efficiency of the U.S. equity markets.

In June 2013, Knight Capital Group (NYSE: KCG) released a study: “Equity Trading in the 21st Century: An Update.” The study authored by professors James Angel of Georgetown University, Larry Harris of the University of Southern California, and Chester Spatt of Carnegie Mellon University, concluded that “the U.S. markets continue to be healthy with low transaction costs, ample market depth and high execution speeds.”

800px-Day_12_Occupy_Wall_Street_September_28_2011_Shankbone_17 2.1They also stated that “gains in market quality documented in 2010 continue and the markets remain significantly more liquid than they were before the growth of electronic trading. They also noted improvements in market quality that have benefited small traders as well as institutional traders executing very large orders over many days.”

Among other findings, their study showed that the intraday volatility of individual stocks, as measured by the high/low range, remains below the levels of the pre-electronic 1990s. While empirical results show that the markets remain healthy, their study concluded that there is room for further improvement of market structures to better serve investors.

The study warned against certain proposals to reform market structures, citing as examples, proposals that impose transaction taxes or costs on trading and minimum resting times on quotes, which the study concludes would hurt liquidity without producing the desired improvements in market quality.

The study is good news for those opposed to increased regulation of the financial markets.  It provides an unbiased and thorough examination of the functioning of the U.S. equity markets. While investors have a legitimate concern about the soundness of the financial markets given the recent hiccups, this study helps to allay some of those concerns.

 

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