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.
Thank you, thank you for making clear issues that I could never quite comprehend.
No kidding. There’s a huge distinction between “using computers to trade really quickly” and “front running every single order that comes through the market”. Rarely gets addressed.
Amen brother! My initial response, reading paragraph by paragraph, was: Yes, Yes, Hell YES!
Best posting on HFT by knowledgable insiders I’ve read. Cheers to the authors! Bar-T, round on me! (I’m in a PUB-lishing mood today – haha)
“the feeling the market is rigged keep many small investors away from the market”
Oh not to worry, they will jump right back in moments before the markets crash again. As far as I can tell, the entire financial system dominated by the Anglo-American megabanks is simply an unimaginably huge and convoluted system that steals earned income of people who perform actual value-adding work and places it into the pockets of rent seeking parasites who all live like royalty and rock stars; a job creation machine for coke dealers, money launderers and hookers. What a wonderful system.
Hopefully the muppets are starting to catch on.
Yeah, the small investors may not trust the stock market, but what choice do they have when bond yields are all but non-existent? Sorry Mr/Mrs/Ms. Retiree, but those t-bills aren’t gonna pay your bills anymore, but your financial manager assures you that he can increase your limited income by putting more of your dough in stocks.
Sound like a con to anyone else?
Yes. The rich need someone to sell their crapified stocks to, otherwise they wouldn’t be rich.
Real estate is the other option, but it requires active management, so most people are still gonna avoid it. *sigh*
“While exchanges are a natural monopoly”
And thus the concept of a “Utility” was born.
The information highway is a toll road run by robber barons. Time to break up this cartel.
A very small transaction tax would be nice.
Alternatively, minimum price intervals of $0.01 (no more ‘you sold 100 shares at 68.0499’ fills) would make most high-frequency trading infeasible.
Excellent idea. The vast majority of investors buy and sell with a granularity no smaller than 1 cent. It would be a refreshing change to buy and sell to human beings , as opposed the servers running batsh*t algorithms.
I can’t think of anything that gets Wall Street more upset than the prospect of transaction fees (including taxes on derivatives) or strengthened regulation.
Having read Flash Boys .. does anyone have any idea how problematic HFT is on other non-American markets ?? Do other markets have the multiple trading sites that allow for time differences?
That was part of Ronan’s telecom job- setting up decentralized and spread out (front-run-able) exchanges in foreign markets. So it seems to be moving in that direction.
“The fact that high frequency trading exists at all is the result of poor regulation.”
And retired SEC lawyer Kidney has ‘blown the whistle’ on why this is so: regulators are led by people that hope for a future financial benefit from those they regulate.
Best explanation I’ve seen. To me the issue is about getting clever minds and effort out of thieving.
“While there may be an economic argument for the elimination of insider trading rules, it comes at the expense of a level playing field. ”
Friendly correction: this is self-contradictory. The “level playing field” is the very essence of economic efficiency. It’s a requirement, which is what economists mean, misleadingly, by an “assumption.”
P.S.: The real objection to insider trading rules is that they’re ineffective.
Lets have another vote for a transaction tax sometimes called a Tobin Tax. The time constaint rule is essential, but so is a minuscule tax that will help our broke gov’t
OK, you can have my vote for a transaction tax large enough that the HFT boys end up paying, oh, say, 110% of their profits in taxes. That ought to solve the problem.
The HFT guys make their money by front-running transactions, but they only make a tiny amount (pennies per share) on each transaction. They get the big money on volume, by front-running EVERY transaction.
Even a very tiny transaction tax — less than 1% — would *completely eliminate* the profits of the HFT guys.
I’d actually go a step further and say I’d be surprised if a significant amount of the effort developers put into HFT systems isn’t aimed at breaking the exchange in some way that can be exploited for profit.
My analogy is online gaming, particularly competitive gaming. In all but the oldest and most robust games, ultra-competitive players typically find it easier to gain an advantage by exploiting weaknesses or glitches in the game engine somehow than by working within the rules. So for example in an open world combat game, rather than kill someone in a fair fight (which requires you to be a better fighter than them) you could just wait by a travel location, attack players as they appear, and rely on the fact that they are typically unable to react for a little while due to network latency and load times. If the game operators notice this and consider it undesirable, they do something to counter it (for example, by making players invulnerable for a short time after traveling) after which the exploiters go looking for another latency effect, game glitch, or other source of advantage that’s easier than relying on their own ability.
Many of the same factors are in play in HFT and the stakes are much higher, so I’d expect all the same behavior to occur. The difference is that what the HF traders gain from the exercise (currency) is the same thing that is used to compensate the overseers and regulators of the system. So they can funnel it into lobbyists and try to influence regulation, so that (to return to the gaming analogy) the game operator ends up deciding that perhaps the undesirable behavior isn’t so bad after all. At which point, if it was a game, it would be considered irreparably broken, and your best bet would be to quit and find a different one to play – preferably one that didn’t have the inherent weakness of being able to use in-game currency to influence the game design and rule system.
The fact that the govt can’t solve even this incredibly simple problem really makes me despair that it can solve the numerous more complicated problems our society faces.
There is absolutely no socially redeeming reason for high-frequency trading. Not even the staunchest free market capitalist can make an argument for how HFT is really a form of efficient capital allocation to generate better investment returns (plus, even the most ardent laissez-faire’ist would have to admit HFT is possible only as a side effect of govt regulation).
And the solution is incredibly simple. Indeed, there are several: implement a tiny financial transaction tax, require any order to be valid for 1 second, require the lowest tick size to be 1 cent (or perhaps a minimum percentage for stocks less than $1.00).
Indeed, our politicians don’t even have to sacrifice favor or graft from Wall St., since many of the investors being fleeced are themselves powerful financial institutions. And yet the government can’t bring itself to solve this incredibly easy problem. What luck do we have of tackling the more complicated issues of the day?
+1. Great use of the gaming metaphor. But unfortunately, using “in-game currency to influence the game design and rule system” is precisely the bigger metagame that the Financiers enjoy playing. Otherwise what edge do they have?