However, catching people at it, and prosecuting them, is tricky. Because of the sheer volume of information about the markets being generated, identifying the hiccups—the strategies designed to break the market for a second for profit—is extremely difficult, and I don’t have a ton of faith in the regulators (or, if I’m being honest, the “self” part of “self-regulating” exchanges) catching on.
Issue 3: The System Itself
Assuming for a moment that we either don’t care about or give up on the information-advantage issue, and succeed in banning/barring/prosecuting the bad actors, there’s still one remaining issue, and that’s system stability.
That’s what Chris Clack was talking about at our Inside ETFs Europe conference a few years ago, when he talked about the inability of the market itself to self-correct when faced with problems. His concern—which I share—is that the real issues here are the unknowns. Nobody predicted the “flash crash” of 2010 because, frankly, not very many people understand the chaotic complexity of the multimarket system for arbitrage; that is how futures, options, underlyings and ETFs all interrelate in one crazy mess.
That systemic chaos is what folks should probably be worried about. HFT in U.S. equities and ETFs is actually a help in this regard, because it’s doing a bang-up job of pointing out all the cracks in the system.
Conclusion: For ETF Investors
So what does all this actually mean for ETF investors? Not much, honestly. Very, very few ETFs trade with enough volume to themselves be the subject of the kind of manipulative, HFT we’re talking about, either from a bad-actor or an information-advantage perspective. Those ETFs that do trade in high-enough volumes trade with penny spreads spot-on fair value, all day, every day.
Where HFT does interact with real ETF investors is in other ways. Part of the reason an ETF trading only a few hundred thousand shares a day (far below HFT levels) can price fairly and easily is because ETF market makers and authorized participants can arbitrage-out price differences with extreme ease. They can access the underlying stocks extremely quickly, and can place basket trades for 1,000 stocks at a time while filling your ETF order to offset their risk.
Does the system need to work exactly like it works now for that arbitrage to function so well? Probably not. Should there be a thoughtful review of the system to ensure that an American-style level playing field exists, that bad actors can be punished and market cracks patched before they cause catastrophes? Certainly.
So if Mr. Lewis’ book, however hyperbolic, gets us there, I guess we can say thank you. Of course, if the reaction is a radical lockdown on the role of electronic trading, I guess we can all go back to bidding our stocks in sixteenths and paying $100-a-trade commissions.
Contact Dave Nadig at [email protected].