- Michael Lewis has recently caused a stir among investors. Whether he’s accurate about high-frequency trading or not depends on how you look at the situation.
- Today’s market spreads are much tighter, often pennies or even a single penny. The result is that, in general, trading is much less expensive than it used to be.
- Institutional investors who are patient traders and retail investors who trade for themselves, both benefit from the much narrower spreads that exist today.
The recent appearance of Michael Lewis, author of Flash Boys: A Wall Street Revolt, on 60 Minutes, created quite a stir about the impact of high-frequency traders (HFTs), claiming the game was, and has been, rigged, with the victims being all investors.
High-frequency trading is a set of computerized trading strategies characterized by extremely short position-holding periods. In high-frequency trading, programs running on high-speed computers analyze massive amounts of market data, using sophisticated algorithms to exploit trading opportunities that may open up for only a fraction of a second. After Lewis' appearance I received many questions about the impact of HFT. Is Lewis right about investors being hurt by HFT? The answer is that it depends.
We'll begin our look at the impact of HFT by observing what has happened to the bid-ask spread - a measure of how expensive it is to trade a given stock. While in the pre-decimalization days you used to be able to drive the proverbial truck through the bid-offer prices on stocks, today spreads are much tighter, often pennies or even a single penny. The result is that, in general, trading is much less expensive than it used to be. The spreads that used to go the market makers have come way down. In fact, the narrow spreads have driven the spreads so far down that it doesn't pay for the old market makers to risk their capital any longer. In effect, in terms of providing liquidity to the market, HFTs have replaced the old market makers. Thus, if the HFT industry is making money, much of it is simply a transfer from one group to another. But with the narrower spreads, total profits are down.
However, there's another side to the story. While the liquidity provided by HFT has led to narrower spreads, the depth of the market has been negatively impacted. The narrower spreads have eliminated the incentive to make deep markets, taking the risks of holding positions. That means you cannot trade large amounts without large "market impact costs" - and that hurts the active traders who "must" move large positions quickly, or at least they think they do. Thus, we have some winners and losers.
Winners and Losers
The winners are the individual investors who can now sell their relatively small amounts of stocks at much narrower spreads, and with much lower commissions as well. In addition, there are institutional money management firms that because of their patient trading strategy benefit from the narrower spreads. And at times they can also provide liquidity to active traders who want to move a large position quickly, and thus have to pay up more today since there is less depth to the market.
Here's what Gus Sauter, Vanguard's Chief Investment Officer prior to his recent retirement, had to say in June of 2010 at an SEC roundtable about the impact of HFTs:
"While today's market structure may not be the optimal structure if one could write on a clean slate, it is significantly better for all investors than the market structure of the 1980's and 1990's. The competition in the marketplace that was facilitated by Reg NMS, the order handling rules, decimalization and improved technology over the past decade has resulted in a significant decrease in transaction costs for all investors. Over the long term, any reduction in transaction costs has a significant impact on investor returns … We think that much of the recent controversy surrounding 'high frequency traders' and 'dark pools' reflects a general lack of understanding of the benefits that such participants bring to the market … We strive to execute those trades at the lowest possible cost. Based on decades of experience, it is our belief that high-frequency trading and dark pools contribute to a more efficient market that benefits all investors. Generally speaking, high-frequency traders provide liquidity and 'knit' together our increasingly fragmented marketplace, resulting in tighter spreads that benefit all investors."
And here is what Cliff Asness, one of the principals and founders of AQR Capital, with about $100 billion of assets under management, had to say about the impact of HFTs:
"Our firm is an institutional investor, primarily managing long-term investment strategies. We do not engage in high-frequency trading strategies. Here is where our interest lies: What is good for us is lower trading costs because it translates into better investment performance and happier clients, which makes our business slightly more valuable. How do we feel about high-frequency trading? We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars. Much of what HFTs do is 'make markets' - that is, be willing to buy or sell stock anytime for the cost of a fraction of the bid-offer spread."
Asness did note that the picture wasn't totally one-sided:
"While we like HFTs on balance for reducing our clients' trading costs, some may push the envelope at times. Some of them may negotiate advantages that might be bad for markets. Worse, these arrangements tend to be little understood by the broader range of market participants. A little more transparency would be good here, and the market venues that have been offering these deals have been moving in that direction. They should move faster. But these concerns are occupying too much attention."
So who are the losers? The losers are the large institutional investors who haven't altered their trading strategies. Thus, to them is seems like HFT is costing them money. But perhaps it's not costing more than it did in the old days when they paid large spreads to market makers. It's just that today they cannot trade large orders as easily, having to make more trades in smaller amounts, and that can lead to markets moving against them faster than they did in the past.
More Volatile Markets
Besides liquidity becoming more expensive, another trade off for the benefits of narrower spreads is that markets have become more volatile, as we have seen in market crashes, such as the "flash crash" of May 6, 2010 when the DJIA fell more than 1,000 points within minutes. Another example is the so-called mini-flash crash of August 1, 2012, when the stock market was roiled by a trading glitch at Knight Capital Group. At 9:30 a.m., while the broad market averages were fairly quiet, 150 stocks traded up to 20 times their normal volume, with many falling 10 percent or more in a matter of seconds, before quickly stabilizing. At the time the Wall Street Journal's Jason Zweig pronounced: "If small investors needed any more reason to be disgusted with the stock market, they got it Wednesday." He went on to add: "Make no mistake: The hearts of many small investors have been broken by the serial setbacks of the past few years." He was questioning whether retail investors would be calling it quits. With that said, let's try and provide some perspective.
First, and most importantly, while HFTs may have been the root cause of some sharp market moves, and their actions may have created havoc at times over very short periods, their actions don't change the fundamental values or long-term pricing of stocks. The impact of their actions which caused the two flash crashes was reversed very quickly. A long-term investor (and there should be no other kind) would not even have noticed the crashes, nor cared.
Second, the types of major market moves that have caused investors concerns aren't exactly new. Recall Monday October 19, 1987, when stock markets around the world crashed, shedding huge values in a very short time. The crash began in Hong Kong and spread west to Europe, hitting the United States after other markets had already sharply declined. The DJIA fell 22.6 percent in one day! Today that would be the equivalent of it falling almost 3,000 points.
Are Reforms Needed?
While most investors have benefited from the narrowing of bid-asked spreads, that's not to say some reforms aren't necessary. However, wide-ranging restrictions on high-frequency trading would likely reduce liquidity in the market and raise costs for all investors. So what can be done?
At a September 2012 Senate Banking Committee hearing on the perils of high-speed trading one of the key witnesses was David Lauer who has helped to design hardware and specialized in studying and understanding the complexities of the rapidly evolving electronic marketplace. He offered the following suggestions to level the playing field and provide more transparency.
1. Unify trading rules, regardless of venue - exchange, ATS, ECN and dark pools should all abide by the same general rules. Require substantial price improvement to internalize flow. This means more than $0.001.
2. To receive a rebate from any venue on which securities are transacted, a market participant must be a genuine registered "market maker" subject to affirmative market making obligations. All such rebates or other compensation must be disclosed.
3. Mandate a unique identifier for every supervisory individual. This ID would have to be attached to every quote submitted to any venue, and provide a mechanism for regulators to associate quotes with the supervisory individual on the trading desk.
4. Eliminate pay‐for‐order‐flow practices.
5. Establish strong, clear market technology standards and regularly audit firms to ensure they are being followed.
6. Revoke order type approval for order types that do not have a clearly demonstrated utility to long‐term investors and market stability.
Others have recommended a small tax be placed on all trades. With the budget deficit issue this should be a popular idea. My own view is that a very small fee, say $0.01 or even perhaps less would be sufficient, along with Lauer's suggestions, to eliminate many of the problems created by HFT, while also raising a bit of revenue - revenue which could be used to bulk up the SEC's enforcement resources. That would go a long way to restoring investor confidence and prevent the game from being rigged, without losing the benefits that HFTs have brought.
While it's impossible to say how each and every trade that's placed has been helped or harmed by HFT, the big winners appear to be institutional investors who are patient traders and retail investors who trade for themselves, both benefiting from the much narrower spreads that exist today. The loser's are the institutional investors who have not adapted their investment and trading strategies to the new paradigm.
For those wanting to read more about this issue, I recommend the following piece: