High frequency trading is suddenly back in the news. Yawn...
HIGH FREQUENCY TRADING has hit the front pages again.
Not because of some new revelations. But because of
the great public-relations team for financial author Michael Lewis. His PR team were able to land him a spot on the famed CBS news
show 60 Minutes last Sunday, talking about his new book, Flash
Boys.
What is High Frequency Trading? Academic study
remains light, almost 4 years after HFT was
blamed for the infamous "flash crash" of May 2010. Government has meantime
been struggling to define it since 2012. But the name HFT goes part of the way to describing the broad
business model. High frequency traders are typically hedge funds, raising
money from wealthy investors who want wealthy returns. They hire
top-of-the-line computer programmers and PhD mathematicians (known as
"quants" in the finance industry). Together, these super-brains
produce automated trading programs using the most advanced computer
power.
The aim? Trade the markets with little or no risk,
creating and executing big or small volume trades on a very regular basis,
and liquidating those transactions profitably in the fastest time possible.
Now, I did not watch the show which aired this past
Sunday night. But I listened to all the jabber on the radio following the
show on my drive into New York City on Monday. A few days later there has
been tremendous outpouring of support for the High Frequency Trading
community, something I did not expect. Still conspiracy theorists revel in
the release of Lewis' new book, and the anti-Wall Street crowd is all in
giggles.
There have already many books on the effects that
HFT has had on the markets, some good and some bad. Sensationalism
is nothing new. But most of what would be
considered the bad is caused not by intent, but by programming that reacted
in a manner that was unforeseen.
Yes, incredible I know, but we are still struggling
as humans to adapt to the new technology we have created. Errors are still
made. These sometimes hurt the markets, but I believe more often than not
this development has been beneficial to the public.
Immediately we recall the famous "flash
crashes", the most ominous being Fat Finger Thursday of May 6, 2010. On this day the stock market collapsed 600 points in a five-minute
period, on what was deemed to have been caused by some computer glitch. It
looks more like there was selling pressure that triggered "algo" trading programs to pull out of the market.
These automated traders, also called HFT just to add confusion, saw a
particular price point go past, and pulled all their orders out of the market
at once, causing a complete disappearance of liquidity.
Such a 5-minute catastrophe is and should be the
most important concern of the regulators. But the recent news however is
causing a distraction into what I believe has been a net positive affect for
longer-term investors, including private retail investors.
Because of the incredible volumes and liquidity
generated by the HFT industry, it has plainly driven the cost of executing
orders down to incredibly
cheap levels compared to those paid less than a decade
ago. This is one important benefit from the involvement of the HFT industry.
HFT is also charged by many (especially Lewis) with
"Front Running" orders. Technically, this practice is where a
stockbroker receives a client order, but acts first for his company's own
account before executing that instruction. This is of course
illegal, because the broker's duty is to
the client. Driving the price higher before executing his/her trade means
profiting from that relationship to the client's detriment.
Today's "front running" claim against the
HFT industry, however, is made because they pay fees for the ability to have
faster access to pricing as it enters the market (system) through the
super-fast speeds and colocation of their computers. Colocation means they
have their own computers in close proximity to that of the exchange. This is
usually a paid for service that is provided by the exchanges. This is deemed
to add another level of unjust advantage.
Michael Lewis claims this colocation enables the HFT
operators to pick pennies from the pockets of investors, adding up to
millions of dollars a day. This is done by getting in front of an
incoming order, and then flipping it back to the same would-be order that in
reality was the driver of the activity.
As an example, it would be as if you were going to
the candy vendor across the street to get a peppermint patty. I happened to overhear
you in the elevator mention it...so I quickly ran across the street and there
was only one peppermint patty left for $1. I bought it though I do not really
want it. When you get to the vendor he is out, but I'll sell mine to you for
$1.10.
Is that front-running in the technical or legal
sense? The HFTs claim they are adding liquidity, and earn the right to trade. Because of their activity, the actual
spreads between bids and offers have tightened which saves the individual
investor money.
I know experts from both sides of the camp and am
not surprised that many of the old guard are against this new way of trading.
Both have valid points but this is not something that should be sensationalized.
Instead, HFT should be justly studied in an impartial manner, and rules set
in place as discoveries and progress is made in our understanding of the
nature and product of this newest trading behavior.
