From Craig Heimark, a recovering derivatives trader, and Yves Smith
The media firestorm over high frequency trading has flagged some legitimate concerns but misses the real issues. While Michael Lewis’ book Flash Boys is sensationalistic and simplistic, it may goad regulators into action, particular since many knowledgeable observers have been making similar arguments for years.
At its foundation, high frequency trading is time-based arbitrage (which is different that statistical arbitrage which involves the real assumption of risk) and that is simply front running. It has become popular to demonize the high frequency trading crowd, but they aren’t the proper targets. The fact that high frequency trading exists at all is the result of poor regulation.
Now some would argue that regulators shouldn’t interfere with high frequency trading – as they also argue that all insider trading rules should be eliminated, since that help ensure that market prices reflect the latest news. While there may be an economic argument for the elimination of insider trading rules, it comes at the expense of a level playing field. Michael Lewis’ claim that “The markets are rigged” has gotten press play precisely because trust in the integrity of the public markets is critical for them to function properly. That implies that equal access to order execution is more important than the academic arguments of greater efficiency.
Perversely, much of the regulation of the last twenty years has been nominally in the interest of “market efficiency” but has come at the expense of market integrity. Far too many of the arguments and studies saying the promotion of competition among exchanges (and dark pools) has led to greater efficiency look at the efficiency as measured by the bid ask spread (plus fees) only of trading in the top stocks (because if they are trade weighted so that is where all the volume is). But this greater efficiency comes at the expense of no reciprocal liquidity obligation (witness the flash crash) as well as reduced liquidity in less frequently traded stocks.
The societal benefit of trading is to reduce cost to raise capital for actual companies. Does anyone really think that narrowing the spread on Google by a penny or two makes any difference to its weighted average cost of capital? In contrast, incidents like the flash crash and the feeling the market is rigged keep many small investors away from the market. The penalty for reduced liquidity in small stocks may actually be material to small company capital formation.
And these small investors are right to be concerned. The old exchange system was a hub and spoke model, which was a stable system architecture. The internet was an outgrowth of a DARPA project to make a communication system so decentralized that it could not be taken out by a nuclear strike. Hub and spoke models are stable, but subject to an outage, say by a nuclear bomb or electrical failure. What chaos theorists have found is that highly decentralized networks are stable, as are single node networks (like exchanges), but that slightly decentralized networks are fragile. And that is what we have now thanks to the SEC’s misguided efforts to “modernize” the stock market via Regulation NMS.
So regulators have left investors with the worse possible market structure. We no longer have liquidity obligations to make orderly markets as we had with the old model. Our current system is more complex due to some decentralization, but it is not so decentralized that it is robust (in technology-speak, a synchronized mesh network). The complexity of keeping the slightly decentralized model synchronized is what makes the system unpredictable and more fragile. This is not just an academic network construct. It is why we saw some exchange crashes recently (like Nasdaq) that were due to code changes in the linkages and feeds between exchanges.
Similarly, the value high speed traders provide is reestablishing the integrity of a single price in a centralized market after Reg NMS fragmented the market. But in reality, the buy side and all brokers are already sophisticated enough to use electronic routing to reestablish that centralized market, but not at sub-second speed. So the only service HFT time-based arbitrage provides is a sub second service. We’ve yet to see anyone make a credible case for the social utility whatsoever of sub-one-second execution. So since sub-second order execution fails to provide any social utility, it follow that any profits they extract are a dead weight loss on stock transactors. Those strategies, with the complex order types and the payment for order flow, should be eliminated.
While exchanges are a natural monopoly like any network, there are, better ways to prevent monopoly abuse than the route US regulators have taken. The SEC should impose minimum resting time for order (which is the equivalent of the IEX 38-mile fiber optic spool that slows down incoming orders). This would not put the high frequency traders out of business; they’d still have statistical arbitrage and other high-value services, but it would eliminate the riskless time-based arbitrage of front running at sub-second intervals.