Kudos to Michael Lewis for bringing the complicated world of high-frequency trading to the public consciousness with publication of his book Flash Boys: A Wall Street Revolt . There’s no little irony in Lewis succeeding in inspiring a lot of interest in the technology-laden darker corners of the capital markets by focusing on some of the people involved and their back stories. It is an engaging narrative with many of the characteristics of good storytelling.
But like many storytellers, Lewis has to pick and choose among the many threads available in weaving his narrative, and the result is a rather broad-brush treatment of trading in the US capital markets. There’s more emphasis on the nefarious banks and brokers who allegedly step in front of client orders for their own benefit, and less attention to changes in market structure in the last decade that have undeniably contributed to tighter spreads and lower trading costs for investors.
As with any complex topic, it isn’t quite as easy as saying that Lewis got it all right or all wrong. There’s outsize attention to algorithmic trading that pings for customer interest and then races to capitalize on prices in other venues that are ever so slightly out of date. The combination of increasingly fragmented markets and aggressive deployment of technology (both hardware and software) allows for “slow market arbitrage” in which customer intentions signaled by an initial trade can be profitably exploited by intermediaries. While this isn’t market manipulation or “rigging the markets,” it is taking a slice of a trade that could have belonged to the investing customer and putting it into the pocket of the bank or broker. And while the system could be abused to engage in front-running of clients, the fact of its existence speaks more to arbitrage across multiple markets for orderly price formation.
The question for investors is whether there is value to this intermediation (through contributions of liquidity and market depth) and, if so, what that value is and how it compares to the money left on the table by the investor that is snatched up by the intermediary. Professional investors spend considerable time and resources on assessing their trading costs and effectiveness, and while there are challenges associated with trading horizons measured in milliseconds on venues that are by design opaque, the necessary cost-benefit analysis doesn’t seem out of reach. Perhaps the difficulty is in accounting for costs and benefits that go beyond trade execution that still inform the decision of who to trade with, including research and corporate access. Investors and those who advise them are paid to ask the right questions about portfolio companies, discern facts from often complex information, and make profitable decisions accordingly. Hardly the passive sheep waiting to be shorn, investors are actually rather well suited to exploring the consequences of who they choose to do business with to execute trades if they are only willing to expend the effort. They should, and in fact most have a fiduciary responsibility to do so.
Lewis spends a bit less time on some other important issues. The notion that application of technology in the market ecosystem is a patchwork of systems that are poorly understood and controlled by even those who own them is a disturbing indictment of the weak resilience of the markets. Flash crashes have thus far been disconcerting and damaging to investor trust, but the ingredients are there for a more catastrophic failure that would severely test investor confidence to say the least. We’ve recommended a variety of measures (including controls on access, circuit breakers, and/or harmonized trading halts across exchanges, and renewed focus on internal risk management controls over electronic strategies and algorithms, as well as sufficient capital to maintain complex systems) to make the system more durable over time.
There’s also some consideration in the book to the perils of complexity, and the potential to confound customers and regulators deliberately out of greedy intent. For example, the exotic order types that have emerged recently are difficult to relate to quality of execution. And the emergence of the “maker-taker” system of payment for orders adds a level of complexity and dimension of dysfunction that we question. These issues are worthy of further study as a component of current market structure, but we need not indict the entire system to disentangle these effects. We’d be wise to consider the risk of unintended consequences of regulatory responses (with the aftereffects of Reg NMS being an excellent example) and applaud generally the entrepreneurial instincts of market solutions that try to address customer needs. But customers need to make their priorities clear and be willing to put their buying power behind their choices, and we should be wary of the political clout of those market participants who have a stake in the status quo.
Meanwhile, let’s have honest conversations with the investors most likely to be jittery after the publicity blitz that accompanied release of the Lewis book. There are costs to investing, some of which are easy to identify and others that are not. There’s no turning back from the evolution of technology, and high-frequency trading is here to stay. It is a system that can be abused to the detriment of investors, but there is nothing fundamentally devious about it as a way to connect buyers and sellers, and the weight of evidence suggests that it has offered mildly positive benefits to investors. A terrific story shouldn’t tempt us to exclude those real benefits in consideration of the best ways to constrain wrongdoing.
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