Who Are Regulators Working to Protect?

by: The Baseline Scenario

This guest post was contributed by Ilya Podolyako, a recent graduate of the Yale Law School, where he was co-chair of the Progressive Law and Economic Policy reading group with James Kwak.

The development of the news coverage of high-frequency trading has been quite interesting. The story started out with a criminal complaint that Goldman Sachs (NYSE:GS) lodged against Sergey Aleynikov, a former employee who allegedly stole some secret computer code from the Goldman network before departing for a new job in Chicago.

Incidentally, Mr. Aleynikov appeared to be headed to Teza Technologies, a company recently started by Mikhail Malyshev, who had previously been in charge of high frequency and algorithmic trading at Citadel, a Chicago-based hybrid fund.

Immediately after the report leaked, Citadel began investigating Mr. Malyshev’s departure and filed a lawsuit to prevent him from getting his nascent business off the ground.

From these facts, some reporters inferred that the surprisingly public maneuvers of two notoriously secretive finance giants vis-à-vis seemingly routine personnel matters showed that Aleynikov had tapped into the gold mine of precious proprietary trading software.

That was two weeks ago. At this point, the story has crescendoed. The New York Times ran a report on high frequency trading. The Economist published a piece on the same topic. Senator Schumer (D-NY) requested that the SEC investigate the matter and the agency acquiesced.

The cynical perspective on these events is that both Schumer’s and Mary Schapiro’s moves with respect to algorithmic trading show that the issue is a red herring. As the argument goes, neither of these actors would touch the practice if it actually underpinned Goldman’s record profits or Citadel’s outstanding performance in 2004-2006.

If, however, banning the practice would eliminate a few small hedge funds and create the appearance of revising market frameworks without threatening the big players (a regulatory brush fire of sorts), high-frequency trading would form the perfect political target.

However, I am not that cynical. I am friends with a few traders (yes, I know, I am tainted), and conversations with these guys always prove pretty interesting. At this point, the securities infrastructure is completely dependent on and permeated by high-speed computers carrying out various tasks.

Some of these tasks are clearly benevolent and straightforward – matching buy orders with sell orders, reporting pricing – while others are probably benevolent but too opaque for us to be certain – concealing large orders by splitting them into chunks.

Of course, certain practices made possible by advanced technology appear downright abusive.

To reliably distinguish the bad strategies from the good ones, regulators must have a clear idea of whom they work to protect. As the financial rescue has demonstrated, life-saving policies for some entities turn out to be a bullet to the head of others. For this reason, market rules should not be guided by some abstract idea of “fairness.”

The concept is alien to trading, and attempts to squeeze it into policy fail quickly because everyone claims that the word means something entirely different. Rather, the SEC and CFTC should seek to remedy specific problems with narrow solutions. If investors of all political orientations can agree that fake prices on public exchanges are a bad thing, the relevant agency should end the practice and move on to the next obvious flaw in the trading process (there is no shortage of these).

By contrast, a roving regulator on a mission to end all fraud before it starts will likely overlook actual problem areas in favor of broad banner initiatives that conceal problems instead of solving them. In this sense, regulatory policy should seek to fight actual enemies, not wage infinite war for infinite peace.

What does all of this have to do with high-frequency trading? Well, a longstanding theory of securities regulation divides investors in capital markets into three classes.

Passive investors are individuals who use their savings to buy stocks for long-term gain. Passivity here is a virtue, not a sin: regular folks do not have the time to research individual companies in great detail, build their own projections, or actively manage a portfolio. They lack the incentive to do so too, since picking individual stocks is a near-certain way to underperform a diversified portfolio.

Thus, the idealized individual investor passively provides capital for functional enterprises throughout the economy and gets a steady annualized return for their services over a long period of time.

Moreover, diversified portfolios make passive investors largely indifferent to whether a particular company fails or pushes a competitor out of business, because the increased earnings of the winner in the fight will displace the losses in the investor’s coffers.

Institutional investors, like mutual funds, form a second group. These enterprises hold large fractions of stock in several companies, either for their own account or on behalf of passive investors. They have the resources to conduct thorough investigations of various corporations and can push the corporations to improve their business practices by electing their own directors to a set of boards.

These moves are impossible for dispersed individuals to carry out because the costs of coordinating and persuading millions of shareholders to do something far outweigh the potential reward from a good decision. Institutional investors, however, immediately profit from good corporate governance because the value of their shares goes up, leading either to capital gain or performance-based fees.

In a well-functioning market, institutional investors are responsible for discovering information and maintaining the competitiveness of individual companies. If one institutional investor uncovers key information that other institutional investors lack and acts on it, the less informed institutional investor loses but all diversified, passive investors win. Moves by institutional investors will usually focus on medium- or long-term profit because such bets allow the firm to amortize the significant cost of information discovery.

The third class of investors consists of speculators. These are individuals or companies making a series of short-term bets on a variety of indicators. Speculators are indifferent to whether a particular asset goes up or down, as long as they were correct in predicting the direction of the price change. Speculators rarely uncover significant new information about an asset on their own, because doing so costs a lot and because short-term price changes often depend on substantive information about what will happen to a business or a product far less than they do on what other individuals think will happen to the business or product. In other words, in the realm of speculators, rumors reign supreme.

Some of these rumors turn out to be accurate, others turn out to be quite false, but the medium-term pricing of an asset sorts the two out. The role of speculators, on the aggregate, is to provide liquidity and supplement high-quality data held by institutional investors with a stream of additional information that may be worth looking at. Speculative trading activity by itself, however, neither adds nor subtracts value, since rumors (by definition ungrounded in previously known material fact) are equally likely to be true or false, and speculators sit on both sides of the transaction.

Within this framework, market regulators should strive to help each group fulfill its objectives without interfering with the roles of the other group. The government should not try to turn passive investors into speculators or vice versa. Instead, it should seek to prevent speculators from spreading intentionally false information, keep institutional investors from cornering markets and acting like monopolists, and protect passive investors from blatant theft a la Bernie Madoff.

In this light, high-frequency trading in itself is not the problem. Speculators can and should be able to buy or sell things as often as they like, since the number of times you make a bet on a roll of dice does not change the probability of a six coming up in any given situation.

Passive investors, who provides the overwhelming bulk of capital to US markets, should not be hurt by high frequency trading because they should be buying assets at the prevailing ask price in 2009 to sell at the prevailing bid price in 2029. Over this holding period, their profit on the investment will be the same regardless of whether the buy and sell orders are executed by humans in yellow coats running around with paper tickets or extremely advanced machines.

Indeed, since people generally cost more to maintain, passive investors should profit from any fancy games that speculators play against each other, provided that the SEC keeps the two camps separate.

That is, a well-functioning regulator should explain to the public that the most speculators lose money because of transaction costs and the cost of capital, and that most individuals can get a far better return on their time from reading a novel than by feverishly checking Yahoo! Finance.

The last thing we as a society would want is to have the SEC announce that, with the elimination of some algorithms, active trading has become a safe and reasonable activity for working families.

Flash orders, however, are an entirely different beast. By probing the market without the intent to complete a purchase or sale, these transactions erode pricing quality by eating up the distance between the publicly known order price and the limit price, a secret rightfully held only by the investor and his servant, the broker.

This pattern of activity means that instead of listing information, providing liquidity, and helping set prices, speculators are actively destroying the ability of a quoted market price to represent the availability of contracts in the market.

If I understand the practice correctly, flash orders are nothing more than a simple bait-and-switch fraud enabled by really expensive computers. They should be made as illegal as other forms of lies about financial products.