There has been a media firestorm over high-frequency trading since Michael Lewis appeared on “60 Minutes” on March 30 to discuss his new book "Flash Boys". But HFT is nothing new. It has been around since at least 1999 when stock exchanges became fully electronic. HFT is a complex and nuanced issue, which requires more than a cursory overview to gain an informed opinion.
HFT is a type of algorithmic trading executed by sophisticated programs run by high-powered computers. These systems automatically buy and sell securities on electronic exchanges where the orders are automatically filled. HFT is computers trading with computers — very quickly.
High-frequency traders have discovered ways to measure (buy/sell) order flow and move faster than many other participants, allowing them to beat other traders to the punch and thus receive better prices for the securities they buy and sell. They aim to capture pennies or even just a fraction of a cent on each trade and make up for low margins by trading at extremely high volumes. According to the New York Times, HFT firms accounted for about half of all U.S. equity trading volume in 2012.
HTFs are mostly competing against other HFTs. Although HFT contributed to volatility in the May 6, 2010 "Flash Crash", it's unclear whether or not HFT is overall good or bad for markets. It's also unclear what the world would be like without HFT and what disruptions there would be in a transition into that world since regulations tend to come with unintended consequences.
IS THE STOCK MARKET 'RIGGED'?
As Oscar Wilde said, “The truth is rarely pure and never simple.”
It's not rigged, but HFTs are skimming pennies. The market isn't rigged in the sense that direction of stock prices are controlled or somehow understood by some participants and not by others. Mr. Lewis overstated his case. I'll stop there because I haven't read his book. But I'm tempted to go further and say that his saying the stock market is rigged is inflammatory and a gimmick to sell more books. If the market were truly rigged, traders would have to be able to profit unfairly by knowing how prices will move in the future. HTFs don't have that kind of edge.
If the market is rigged, it's rigged by the Federal Reserve on behalf of itself, the largest banks and the government. But that's a subject for another post.
The edge HFTs have is that they can measure order flow in markets and move faster than many other participants, giving them the ability to outmaneuver other traders. They've achieved this by building ultrafast computers working on ultrafast networks linked by high-capacity connections to the exchanges. They're not doing anything illegal. The question is shout it be?
On the surface, the answer, probably, is yes. But HFT isn't the kind of issue you can address by looking at the surface. Understanding HFT and how/if to regulate it requires deep understanding and thoughtful analysis — something governments try endlessly to do but are notoriously terrible at doing.
Before one can have a well-informed opinion on whether HFT should be prohibited, regulated or neither, one must think about many other important questions, such as:
• Do HFTs serve anyone but themselves?
• What value, if any, do they provide to non-HFT investors?
• Which investors do they provide value to? Which investors do they harm?
• What costs are being imposed on non-HFT investors?
• How would the markets function without HFTs?
• What would the transition to a market without HFTs be like?
• Could government outlaw HFTs effectively? Could government regulate HFTs effectively?
• What would prohibition or regulation look like? How much would it cost the government to enforce it? Where would that money come from? Would the costs outweigh the benefits?
These questions are important and hard to answer. I have opinions on some of these questions, but I'm far from convinced on most of them.
The fact is, HFTs are skimming pennies from investors. Several years ago, the founder of Tradebot, one of the biggest high-frequency firms, said that the firm had “not had a losing day of trading in four years.” Some call it legalized theft. I don't argue with that characterization but unfortunately it doesn't make HFTs any easier to deal with.
Yes, HFT is a cost to investors. Yes, HFT is encouraged by the exchanges because they like the source of revenue. And, yes, HFT is allowed by the Securities and Exchange Commission. Why the SEC allows it isn't clear. I'm a devoted skeptic of government and top-down, central planning, but, in the case of HFT, I think government is right to be skeptical of the potential solutions because medicine could be worse than the disease. Especially if the medicine is too strong.
The cost HFTs impose on investors is small. In fact, investors get better order executions today than they have ever had before. These aren't points in defense of HFT. These two points, along with all questions I listed above are the reasons HFT hasn't been regulated or outlawed yet.
In a report published in December 2012 called “High Frequency Trading — The Good, The Bad, and The Regulation,” Credit Suisse Group AG concluded that although high-frequency trading often is viewed as entirely negative, not all behaviors are detrimental to the market and HFT has probably led to an improvement in market quality overall. They also concluded that “it is clear that undesirable behavior exists” and suggested some possible regulations to improve the marketplace while also warning against other regulations that “seem prone to unintended consequences, especially where their scope is broad.”
The largest players in the markets will continue to have influence … until they don't. When the markets have their say, those players will continue to try to have influence and will be ineffective. Then the media war will ensue, propaganda will fly and the blame game will be played out. This is the minefield investors are forced to navigate.
Buying and holding stocks is the only way to ensure you'll be holding the bag during the next crash. To be fair, it's also the only way to guarantee you'll be holding the bag if/when markets go to the moon and/or recover from their depths. A better approach, I think, is to adopt an active, trend-following strategy that may protect you from disaster and help you participate in markets when they're trending higher.
With stocks reaching new all-time highs again last week, investors are faced with the most challenging task. Regulators don't have their own skin in the game and HFT firms have most of their skin in the bank. That's why I think being a passive, “buy-and-hope” investor right now is very risky.
When it comes to regulation, I think Rick Santelli got it right in this clip “Why is HFT tolerated?" His key point was this:
“Why is it that anybody would want HFT to be unchallenged or at least not challenge it now? My reason, this is just my reason, when I look at the stock market, it's basically at historic highs. When I look at what the Federal Reserve is doing, it's mostly to put stocks on all-time highs. When I look at all the debt and all the programs that don't seem to be making a difference except for putting stocks on all-time highs, I see that you have this tower of power with regard to the stock market. And nobody wants to challenge or alter HFT because it is good to go that many days without having a loss. So my guess is, when the stock market eventually deals with reality and pricing, which will come at a time when there's not a zero interest rate policy and we're long past QE, I think they'll address it.”
My concern is that, after the next market crash — whenever it comes — the government will blame HFT in an attempt to evade the truth, which is that the Federal Reserve is responsible for manipulating markets and driving asset prices to unstable highs.
The former chairman of Morgan Stanley Asia, Stephen Roach, hit the nail on the head when he said “flash traders are bit players compared to the biggest rigger of all, which is the Fed." After the next crash, regulators are going to do everything they can to deflect attention from themselves and the institutions they control.
WHAT SHOULD BE DONE ABOUT HFT
Either nothing or very targeted measures. Let me explain.
The suggestion that came from Credit Suisse in December 2012 seems to make sense. In that report, the firm suggested a targeted measure that would limit “order-to-trade ratios.” By implementing limits on how many orders can be canceled after they've been entered, exchanges can regulate at least one of the bad practices of HFTs, “quote stuffing,” where traders send large numbers of orders and then cancel some or all of them. If that mechanism works, others could be tried. My main concern is that a broad regulation(s), such as outlawing HFT all together, would have unintended consequences that could harm many innocent people.
On Friday, CNN reported that Attorney General Eric Holder is launching an investigation. That's good news, I suppose, as long as the agency proceeds carefully.
In the end, I agree with Michael Lewis, as he explained in his C-SPAN Book TV interview over the weekend. The best solution probably isn't to have lawmakers — as influenced as they are by Wall Street — craft new regulations. The best solution is probably a market-based solution, such as the protagonist in "Flash Boys." If there's one thing we do know, it's that Congress and Wall Street don't specialize in transparency. And above all, that's what's needed here.