The Effect of Corporate Governance on High Frequency Trading Habits

The days of calling your broker to place a trade over the phone are over.  In fact, the new breed of Wall Street traders that are under 30 years old have probably never placed a trade over the phone.  In today’s trading world, billions of dollars are moved in financial markets with the click of a mouse.  This transition to electronic trading has made many market operations more efficient, but it has not come without costs.

The rise of technology and electronic trading has helped birth an entirely new method of trading—high frequency trading.  In high frequency trading, traders will hold trades for anywhere from a few seconds to mere milliseconds.  These trades happen so fast that humans could never execute them; instead, they are run by million dollar computers. 

Unfortunately for Wall Street traders, many economists and financial analysts are blaming high frequency trading for several major catastrophes over the last two years in financial markets.  The largest one is the Flash Crash that occurred in May 2010 as the stock market plunged nearly 1,000 points in a few minutes before recovering much of its losses in the next hour.

That day made it clear that high frequency electronic trading could be extremely dangerous, and, therefore, the scrutiny has intensified.  Lawmakers in Washington are pushing for much stronger regulation concerning high frequency trading; they have already passed laws that have made this style of trading more difficult, including the inability to hedge, or hold simultaneous long and short positions in one asset.

However, there is one type of regulation outside of Washington that actually has the power to bring strong changes for the better to high frequency trading.  That type of regulation is corporate governance.  Many firms that engage in forex scalping, for instance, have very little if any corporate governance determining what is acceptable and what is not.  Therefore, traders and investment managers fall prey to greed and other destructive emotions and begin developing models and engaging in trading behaviors that simply are bad for financial markets as a whole.

Ugur Lel is an economist with the Federal Reserve who works in the Division of International.  He recently wrote an essay entitled, “Currency Hedging and Corporate Governance:  A Cross-Country Analysis.”  Lel’s analysis and findings are quite fascinating.  He discovered a very tight correlation between firms with strong corporate governance and their trading practices.  Typically, firms that have instituted strong corporate governance tend to employ trading strategies for value-maximizing reasons, while firms with weak corporate governance tend to use trading strategies based primarily on self-interests of the management team—aka greed.

The idea that corporate governance could be used as a self-regulatory function of financial firms is well accepted among politicians and economists who believe in free-market principles.  But here’s the catch: in a true free market, firms should be allowed to fail.  If they are not, then a firm can engage in risky, unethical trading, and then just get bailed out when times get bad.  This creates a moral hazard.

Therefore, there are two basic solutions to the problem of forex and equity high frequency trading.  Let the free market work.  Good firms will institute strong corporate governance.  Bad firms will not, but they will fail.  When they do, other firms will notice and after a period of time, firms will mostly operate with strong corporate governance.  The second option is to bring heavy-handed regulation into financial markets.

Jennifer Gorton is a Guest Contributor.  She is the content manager of Forex Traders, a portal to understanding forex.  Her goal is to produce educational and practical information concerning the ever-changing financial world.