Are you frightened of high-frequency trading (HFT)? Are you concerned about what it might do to your stock portfolio?
If so, you may have been exposed to Michael Lewis over the past few months. It’s been hard not to be, especially if you watch financial shows on TV or read the financial press. He’s been everywhere, giving interviews and promoting his blockbuster new book, Flash Boys: A Wall Street Revolt.
But is he right?
Lewis’ premise: the advent of HFT means that stock markets are now “rigged for the benefit of insiders,” as the book’s jacket flap notes inform us. And if that’s not frightening enough, it goes on to state, “The light that Lewis shines into the darkest corners of the financial world may not be good for your blood pressure, because if you have any contact with the market, even a retirement account, this story is happening to you.”
That’s great copy, isn’t it? Any good publisher understands that the easiest way to get people’s attention is to scare the crap out of them. Notions of shadowy conspiracies also work. And who wouldn’t want to know what’s going on in those darkest corners of the financial world?
Problem is, we’re already aware of what’s been happening in Wall Street’s figurative back rooms. We’ve been exposed to many of the big banks’ secrets, such as that many of them profited enormously from the crash of ‘08 by making huge bets against the very junk mortgage securities they were simultaneously promoting to their clients. Compared to that level of darkness, high-frequency trading is a sunny day in June.
But Michael Lewis delves into some important issues. Central among them is a pair of questions. Are the markets “rigged?” And if so, should we be concerned? I would answer yes and yes, but not for the reasons Lewis advances in his book.
The New Normal
Maybe someone without access to media of any kind might still believe that markets aren’t rigged, but the rest of us know that they are. The interest rate market, for example, is completely rigged by definition, since our central bank manipulates the cost of money at its whim.
With gold, the market is small enough that traders with sufficiently deep pockets, like the biggest banks, can push prices up or down to their hearts’ content.
With stocks, prices are sometimes rigged openly, such as when Washington prohibited short sales during the meltdown… and sometimes more subtly, as when the Fed buoys prices by pushing trillions in funny money into the system. The giant investment banks employ any number of shady tricks, such as arranging large transactions inside their “dark pools”—where buyers and sellers can connect directly and not affect the public stock price by going through an exchange. And there are always the market makers. As middlemen, their job is to provide liquidity, which they do by rigging the bid/ask spread (in such a way as to ensure profits for themselves, of course). They’ve been known to widen those spreads unjustifiably, and no one ever says, “Hey, wait a minute…”.
These are all concerns, sure, but they aren’t what Lewis writes about. His focus is on high-frequency traders, what they do, and why it’s so evil.
One of the bothersome things about the book is that Lewis presents his research with a “Wow, look at this mind-boggling secret I just uncovered” approach. And TV’s talking heads have largely gone along with him, expressing their shock. But we’ve known all about HFT for a long time. In fact, I wrote an article for Casey Extraordinary Technology that explained it 2.5 years ago, and since then both Alex Daley and I have expanded on the subject in this space.
Let’s be clear: no one completely understands what HFT is doing to the markets. While a human high-frequency trader may have a general idea of what his algorithm is up to—though even that is in question as advanced forms of artificial intelligence (AI) are now used to let the computer dynamically make up new rules regarding how to trade—that doesn’t mean he knows the net effect of its actions. With thousands of systems battling against each other, making millions of trades, it quickly becomes obvious that people are on the outside looking in—pretty ignorant of what these arrays of supercomputers are cooking up on their own at any given moment.
When HFT comprises the bulk of all market trading—as it does today, as shown by the image above—this introduces an element of risk that wasn’t there before, true enough. It could blow up in some utterly unpredictable way. But for the most part, HFT simply does what market participants have always done, albeit way faster—and in a manner that hovers over the border of illegality. It may even cross that line.
The health of the stock market depends on the maintenance of liquidity and the promise that when anyone wants to buy or sell an equity, he or she will be able to, at around a price that’s been publicly quoted and is reasonably close to the one the broker provides or that appears on the computer monitor. (For some basics on how this works, the SEC has provided a brief primer.)
The actual final price depends on what the bid/ask spread is at the moment of execution.
What’s in a Ping?
Many HFT algorithms seek to control bid/ask spreads by “pinging.” This means using an algorithm to scour the entire market, placing huge numbers of orders at light speed and immediately withdrawing them. This continues until the algo gets a hit that lets it buy and quickly sell a stock over the course of a few milliseconds, skimming a tiny profit off the transaction, typically a penny per share or even less. An insignificant amount for that one deal, but when they accrete over the course of a day in which millions of such trades might be made, it adds up. And each trader’s profitability has zero correlation with how any stock or the overall market performed. All that matters is that their algos were better than the next guy’s.
Thus HFT traders are not, strictly speaking, traders at all. Their pings are not real orders, but rather a way of divining information about the intentions of real investors in the next 20 microseconds. At the end of the day, the HFT guys own no shares whatsoever—they just count their money.
Also strictly speaking, pinging is illegal. No one is supposed to place buy or sell orders that they have no intention of honoring, reasonably enough. Prior to HFT, this wasn’t a problem, because it was difficult to withdraw an electronic order before it was executed. Now it’s easy if you have the right tools. And it’s impossible for regulators to effectively police activities that happen countless millions of times every trading day without the rules they enforce being changed from the top.
Market participants are also supposed to be protected by the SEC’s National Best Bid and Offer regulation (NBBO), which states that a broker must secure for his client the best available ask price when buying securities, and the best available bid price when selling them. But the HFT’s superfast market connections allow him to step in front of the retail customer and pilfer the best bids or asks before that customer can get to them.
They do it through another potentially illegal practice: front-running. Technically, the government forbids anyone from having access to information that isn’t simultaneously available to everyone. If, for example, I were the only trader who knew that you were about to sell 100 shares of XYZ at a given offer price and I knew that before all of my competitors, it would give me an advantage in finding a buyer and setting a price favorable to me. That’s called front-running; it’s deemed by the authorities to be unfair; and in an attempt to control it, the government requires any changes in a stock’s price to be universally posted immediately (outside of dark pool transactions, but that’s another story).
Yet front-running is precisely what HF traders routinely do. And because of latencies within the system—measured in microseconds but nevertheless exploitable—it can’t be prevented.
The prime example of this is something dubbed “slow market arbitrage.” It generates more profit for HF traders than all of their many other strategies combined. Slow market arbitrage takes advantage of the proliferation of exchanges that has happened in recent years. Gone are the days when the stock market consisted of the NYSE, NASDAQ, and AMEX. Now, there are a slew of new ones, such as BATS and Direct Edge.
Most were created more or less just to service HFT, and thus they handle enormous numbers of “transactions,” more than 99% of which are never executed. And to accommodate their HFT friends, they will sometimes route large incoming orders to favored customers microseconds ahead of the rest of the pack. In addition, they invented a bunch of new order types that go way beyond market and limit orders—with peculiar, uninformative names like Post-Only and Hide Not Slide. These are so exotic that most ordinary brokers don’t even understand them, much less have the ability to execute them. But what they have in common is that they aren’t truly vehicles for trading. They exist only to help HFT participants secure a fleeting market advantage.
Among the orders that are consummated, however, are the slow market arbitrages. It works like this: a high frequency trader’s computers can see a price change on one exchange, and in the few microseconds it takes for that change to be reflected everywhere, they’re able to pick off shares on another exchange that hasn’t yet reacted, profiting from the difference.
These are just a few examples of what makes HFT tick. The actual market is far more complex. Yet in a way, it’s also more simple: HFT is now the price-discovery mechanism in US equity markets. That’s just reality. In fact, it can be argued (and is, by proponents) that HFT has birthed the fairest, most efficient, and smoothest-running market in history. The cost we incur to get that system is the penny a share collected at the HFT tollbooth.
So, Is It Rigged?
Whether this is a creative use of technology or merely a form of market rigging is not debatable to Michael Lewis. “The stock market at bottom was rigged,” he asserts. “The icon of global capitalism was a fraud.”
But before jumping to that conclusion, here are some key questions worth asking: How is what HFT does fundamentally different from the commissions taken by market makers—or retail brokers, for that matter? Because it’s “cheating”? And should government barge in and drop the hammer on HFT, as it seems likely to do at some point? How much havoc will that cause?
The thing that probably bothers people most about HFT is that it’s opaque. You not only don’t know what’s going on in there, you can’t know. Only the artificial intelligence knows for sure, and it’s talking too fast for a human to follow. Moreover, when you have these thousands of supercomputers interacting with each other without operator guidance, then of course there’s always the possibility that one of them will make a particular move that sets off a cascade of automated events. With potentially catastrophic consequences.
But what are the chances of that? Well, consider this: Market disasters generally result from risk that exceeds supportable levels. The collapse of ‘08 was triggered by the trading and re-trading of mortgage-backed securities that couldn’t be accurately valued. With each trade, the risk was magnified some more, until it finally overwhelmed the system. Or take the dot-com crash, which came about because the price of revenue-free startup companies was bid so high that the risk of continuing to hold them blew way past the probability of selling to the next sucker in line.
HFT, on the other hand, is about the exact opposite—mitigating risk. It captures profit by engineering trades that depend on zero volatility. In order to be successful, it must ensure that a stock price doesn’t stray beyond the limits it sets. Most HF trades don’t move the posted ticker price of an equity at all; everything happens within a bid/ask spread that changes so fast it’s imperceptible to anything or anyone outside of the host computers.
As a market stabilizer, proponents say, HFT has become indispensable. They point to the infamous Flash Crash of ‘10, which took the Dow down nearly 1,000 points in 20 minutes.
The trigger for that was a simple human error. HFT quickly re-priced securities and stair-stepped them back up to their proper levels, it is argued, thereby reversing the crash before it could spin entirely out of control.
Michael Lewis is very focused on the dark side of HFT, and he stirs that pot for all he’s worth (he wants to sell books, after all). But when he reaches the conclusion of his story and confronts why HFT is bad, he finds he doesn’t have much to say. First he cites instability, but doesn’t give the counterargument any space. Then he goes off on a goofy rant about how these people are wasting their lives. And finally, he gives us this: The money collected by HF traders is “a tax on investment, paid for by the economy; and the more that productive enterprise must pay for capital, the less productive enterprise there will be.”
Do you know what that even means? I’m not sure I do.
But I think it’s wrong. When a company first sells its shares to the market to raise capital, it sets a price with buyers offline. HF traders only step in when those buyers want to resell their shares and get out—and in that case, like any other, those buyers are probably happy to have 300% more liquidity because of HF traders occupying most of the market. That’s what allows those stocks to trade in seconds instead of minutes or hours.
HFT and Your Bank Account
The more personal issue is how HFT affects the individual investor. Does it matter? Should you care about it?
My answer is: don’t bother. If someone is skimming a penny from each share you trade, you’re not even going to notice. Besides, if you know roughly what you want to buy or sell your shares for, you can protect yourself from any of these intermediaries just by placing a limit order that locks in your maximum buy or minimum sell price. It’s the only kind I ever use.
Simple as that, enemy neutralized. Is any adversary so easily thwarted really worth worrying about to begin with?
The truth is that we at Casey Extraordinary Technology are not so very different from HFT. No, this is not what our Vermont HQ looks like:
We don’t have any tech more powerful than an off-the-shelf Apple or PC computer. But just as HFT’s algos search for anomalies, so do we. We merely call them by a different name—undiscovered opportunities—and we find them the old-fashioned way. Through tough, exhaustive and impartial research. Our profit window also differs; it’s measured in months, not microseconds. We’re pretty good at this. Check out our track record, and if you like what you see, take us for a risk-free 3-month spin.