Debating Michael Lewis’ “Flash Boys”: High-Frequency Trading Not All Bad

Categories: Americas, Market Structure
Stocks

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that pings for customer interest and then races to capitalize on prices in other venues that are ever so slightly out of date.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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Photo credit: iStockphoto.com/a-wrangler

11 comments on “Debating Michael Lewis’ “Flash Boys”: High-Frequency Trading Not All Bad

  1. C Lance Durham said:

    If they find out one is buying in market A and then go and buy in market B, then there was already liquidity in market B.

    If there was already liquidity in market B such that they could buy in market B, then they are not adding liquidity in market B. Thus, the primary argument for them fails.

    Regarding other arguments such as falling spreads or depth, they are no comfort. If transactions go up 2X, but only because these guys are inserting themselves into the trade, that is not really improving the depth. If spreads go down by half, but they inserted themselves into the trade, then that is not really improving the spread. …Thus, these arguments fail as well.

    Regards,
    Lance

  2. Bob Dannhauser, CFA said:

    @C Lance Durham – thanks for your comment. Liquidity attributable to HFT can indeed be illusory if all they are doing is intermediating, but it isn’t clear that that’s the case. Such traders may in fact be real sources of liquidity that narrow spreads, and academic study of this question seems to support this notion (see for example a nice summary with references to this by CFA charterholder Douglas Cumming in last week’s Financial Post). We’re especially interested in studying some of the other factors that affect liquidity in connection with HFT (including order routing methodologies and incentives for order flow.)

  3. I agree with the bulk of your conclusion which is that computerized trading has brought the cost of investing way down for investors. We wrote a blog post on this same topic for our investors and came to a very similar conclusion. I think where we disagree is, although small and rather irrelevant for a long-term investor, HFT programs (as explained by Michael Lewis and Brad Katsuyama) are front running trades. The skim they are taking is small, but the size of the skim doesn’t justify the actions. Computerized trading is great…computerized scalping should be illegal.

    http://www.seasoninvestments.com/insights/weeklyinsights/is-investing-a-rigged-game/

  4. Fred Smoak said:

    They aren’t adding any liquidity to the markets if all they are doing is stepping in front of already-placed trades. You can look at their trading records and how often they post losses to see they aren’t risking their capital. Not impressed with this article.

  5. Bob,

    Are you saying that HFT was created in order to promote social welfare, liquidity and market stability? Give me a break! If you call the market moving away from me because of front running a good thing then you’re just playing spin doctor. HFT and FLASH crashes cause more mistrust in Wall Street by Main Street and that is never a positive for the industry to which I have dedicated my career. Your article is a blatant insult to intelligent people and probably self-serving.

  6. Bob Dannhauser, CFA said:

    @JamesBTharin and @MarcDenoyer, thanks for your comments. Mr. Tharin, you might find this research (http://heartland.org/sites/default/files/htf.pdf) interesting; just one study, but it looks specifically at the issue of prevalence of HFT front-running and finds no evidence of systematic front-running of non-HFT market participants. That isn’t to say it can’t – and doesn’t – happen, but we’d argue that HFT itself isn’t the problem.

  7. James Tharin said:

    Thanks for directing me to the study. After just reading the abstract it became obvious what the author’s point of view is. The abstract had seven or eight conclusions, all of which supported the merits of HFT. If you google the author, it won’t take long to figure out where his loyalties are. Everybody that seems to agree with the points that you raise appears to be making money on HFT. I have no problem with speed, but I do believe that front running is a violation of the code of ethics. I’m surprised that you are taking this position given your position at CFAI. One question that I do have is “how does HFT provide liquidity when a security is purchased thereby reducing supply and then quickly sold at a higher price?” That’s market manipulation 101. Anybody with half a brain knows that if the HFT traders are picking up pennies at enough of a rate to make enough money to justify the money being spent on the technology to do so then the profits are coming out of somebody’s pockets. If the profit isn’t coming from the muppets then where is it coming from?

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