High-frequency trading is back in the spotlight, which could lead to improvements or knee-jerk catastrophes.
Anytime Michael Lewis writes a book, it’s a good time to be a reader. He’s a great storyteller. And he’s always provocative. His latest book, “Flash Boys”—which I have on order but have not read—will likely be no different. But good stories need stark lines in the sand, and so far, it’s pretty clear that Lewis’ is painting high-frequency trading (HFT) as an unadulterated evil.
The reality, of course, is a lot more complex and nuanced. But nuance rarely, if ever sells. To get nuance, you need to turn to people who don’t really have a horse in the race. The real question we should be asking is, Does HFT serve a useful purpose for society, and if it does, is it worth whatever external costs there might be?
It’s really not much different than, say, evaluating whether or not to pave the road in front of your house. It costs money. It damages the environment. But darn it if a nice paved road doesn’t get me to the office a lot faster.
In a recent (as in, officially published last week) paper, Bruno Biais, Thierry Foucault and Sophie Moinas look at the social welfare implications of HFT, although the paper’s titular focus is on the actual amount of money being invested in HFT infrastructure.
It’s a blisteringly mathematical paper, but the conclusion, thankfully, is written in good old-fashioned English: “Investment in fast trading technology helps financial institutions cope with market fragmentation. To the extent that this enhances their ability to reap mutual gains from trade, it improves social welfare. On the other hand, fast institutions observe value relevant information before slow ones, which creates adverse selection, lowering welfare. Thus fast trading generates a negative externality.”
Problem 1: Information Flow
I admit, this is arcane language, and a whole lot less catchy than the money-quote from Michael Lewis’ new book, “Flash Boys”: “The United States stock market, the most iconic market in global capitalism, is rigged.” But they’re actually making the nuanced point—there is a societal good here, but there’s also a problem, and that problem isn’t one of a game being rigged—an image that conjures up the gambling façade from “The Sting.” It’s simply a problem of information flow.
Looked at from another angle, HFT is just a single narrow slice of what happens when you have a world moving faster in every way. Not to get too philosophical, but the really interesting work being done on trading isn’t about trading, per se, it’s about changing our understanding of time.
In another (super nerdy) paper in the Review of Financial Studies in 2012 (from David Easley, Marcos Lopez de Prado and Maureen O’Hara) the authors challenge the very idea of even thinking about “time” when it comes to trading. They posit that what really matters is a new metric where all you care about is how many trades happen. The ideas is that “slow” trading (an ETF that trades 100 times a day) has similar characteristics to “fast” trading (an ETF that trades 100 times a second). All that changes is the nature of useful information.
In the “slow” ETF, you care about “slow” data, like an earnings release. In a “fast” ETF, where the holding period may be minutes instead of weeks, you care about “fast” data. And what kind of data is that? Data about the nature of trading itself.
By getting access to the “fast” data, the HFT crowd gains an edge because they can anticipate order flow and get ahead of it. Let’s be clear—that’s a bad thing. All else being equal, having inside information about any part of the capital markets process is likely something that we, as a society, want to squash as best we can. We want a level playing field. There’s something uniquely American about that, and I’m all in.
Regulation FD (Fair Disclosure) is supposed to make any inside information a no-no. That’s the big argument many folks are making about HFT early information—it’s against Reg FD. And it’s certainly against the spirit of it. Still, there are plenty of folks out there who just consider this traders being rewarded for being smart, and that smart traders have always had an advantage.
Issue 2: Bad Actors
No, I’m not talking about Nicholas Cage. I’m talking about how HFT enables bad behavior.
The second thing HFT brings to the party that can be outright negative is an opportunity for abuse. Here’s where I actually have some concern. While the early-information advantage is a bad thing, the reality is it’s not actually costing the long-term, buy-and-hold investor much, if anything. It’s an annoyance, and one I’d likely stomach for a smoothly functioning, penny-spread market.
The problem is that HFT firms, by nature of their hardware and access, can actually break the market, essentially at will. Numerous reviews have talked about “quote stuffing” and other nefarious strategies deliberately being used to expose cracks in the actual market infrastructure—cracks that allow the bad actor to get executions when nobody else can. Obviously that kind of activity should be (and is) illegal.
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].