- Goldman Sachs is worried the increasing dominance of computerized trading may cause more volatility during market downturns.
- The firm says high-frequency trading machines may "withdraw liquidity" at the worst possible moment in the next financial crisis.
Goldman Sachs is cautioning its clients that computerized trading may exacerbate the volatility of the next big market sell-off.
"One theory that has been proposed for why market fragility could be higher today is that because HFTs [high-frequency trading] supply liquidity without taking into account fundamental information, they are forced to withdraw liquidity during periods of market stress to avoid being adversely selected," Charles Himmelberg, co-head of global markets research at Goldman, said in a report Tuesday. "In our view, this at least raises the risk that as machines have replaced people, and speed has replaced capital, the inability of the market's liquidity providers to process complex information may lead to surprisingly large drops in liquidity when the next crisis hits."
Himmelberg noted the higher level of computerized trading has not been truly "stress tested" during the bull market since the financial crisis. He said the increasing incidents of volatility in various markets such as the VIX spike on Feb. 5, the 10-year Treasury bond on Oct. 15, 2014, and the British pound on Oct. 6, 2016, may be precursors of a bigger one to come.
"The rising frequency of 'flash crashes' across many major markets may be an important early warning sign that something is not quite right with the current state of trading liquidity," he said. "These warning signs plus the rapid growth of high-frequency trading (HFT) and its near-total dominance in many of the largest and most widely traded markets prompt us to more carefully consider the possibility (not necessarily the probability) that the long expansion accompanied by relatively low market volatility may have helped disguise an under-appreciated rise in 'market fragility.'"
The strategist said computerized trading is generally not backed by large levels of capital, which could drive the "collapse" of liquidity if the machines suffer any big losses during a significant market downturn.
"Future flash crashes may not end well," he warned. "The quality of trading liquidity for even the biggest, most heavily-traded markets should not be taken for granted."
— With reporting by CNBC's Michael Bloom.