High-frequency trading (“HFT”) is an issue that has been simmering for some time. In September, the Commodity Futures Trading Commission (“CFTC”) published a Concept Release on controlling risk and safeguarding automated trading environments in an attempt to get its arms around an extraordinarily complex new regulatory challenge. Hard on its heels, the SEC released MIDAS, a sophisticated graphic tool that allows users to measure orders and cancelations in the merest fractions of a second. But while the ins and outs of HFT and its purported benefits and demerits were the subject of discussion in the financial world, nobody in the wider world seemed to be paying much attention.
Last week the pot boiled over, and the wider world sat up and took notice. Michael Lewis’ book “Flash Boys” hit the shelves and he appeared on 60 Minutes to pronounce “the stock market is rigged.” The once arcane subject of high-speed automated trading has since consumed a public already profoundly skeptical of Wall Street and its impenetrable ways.
The New York Times Magazine ran a lengthy excerpt of Lewis’ book describing how a young trader for the Royal Bank of Canada named Brad Katsuyama uncovered the reason why the market for his electronic trades mysteriously changed the moment he executed them – his orders were essentially being preempted by traders whose physical proximity to the exchanges gave their computers an infinitesimally small advantage in capturing and front-running Katsuyama’s orders. As Lewis describes it, what Katsuyama discovered was a kind of slow-market arbitrage. “This occurred when a high-frequency trader was able to see the price of a stock change on one exchange and pick off orders sitting on other exchanges before those exchanges were able to react. This happened all day, every day, and very likely generated … billions of dollars a year…” Lewis summed up the gambit like this: “The same system that once gave us subprime-mortgage collateralized debt obligations no investor could possibly truly understand now gave us stock-market trades involving fractions of a penny that occurred at unsafe speeds using order types that no investor could possibly truly understand.”
Katsuyama was shocked at what he found and couldn’t believe that he, an outsider working for what was regarded as a conservative and sleepy backwater bank, had uncovered something other far more sophisticated players were not aware of. Eventually he realized that he was not alone in his ignorance: many of the most sophisticated investors had no idea what was going on, not even industry giants like Fidelity and Vanguard. Well, people know now. Katsuyama made it his mission to meet with hundreds of investors to educate them about the realities of HFT. And now Lewis’ book and 60 Minutes appearance have brought the matter to a very public head.
Zachary Karabell, writing at Slate says the current debate and the negative spotlight cast on high-frequency trading should be welcome, but doesn’t believe that behavior that was previously deemed acceptable should be suddenly criminalized just because the pendulum shifts.
Bloomberg’s Matt Levine posits that high-frequency trading may be too efficient. He imagines a world where high-frequency trading is so speedy and efficient that there’s no way for fundamental investors to make any money. When high-frequency trading firms could instantly capture all of a trader’s profits, no one would bother with investment research, because any information advantage obtained by research would disappear instantly the minute you tried to buy stock. “The market would be left to no one but the hobbyists and the high frequency traders, neither of whom are much good at the fundamental analysis that in theory should go into allocating capital.” Similarly, Floyd Norris writing in the New York Times, argues that more and more computerization will drive out middlemen — making the market even more vulnerable to disruption as it becomes less attractive for those who provide liquidity. What is needed, he says, is a way to require those who profit from providing liquidity in good times to continue to provide it when times are hard. And, if something goes truly haywire, to let humans call a halt until the wild computers can be tamed.
Writing for the New York Times, Nancy Folbre argues that tolerance of this high-tech front-running challenges the faith that competition always guarantees efficient outcomes and the creed that market value accurately measures real contributions. Some titans of the financial world, she says, including the redoubtable Charles Schwab, agree. Schwab described HFT as a “growing cancer that needs to be addressed,” one that it is “designed to pick the pockets of legitimate market participants.”
Jack Bogle, the fabled founder of Vanguard, disagrees. A frequent critic of Wall Street, Bogle told CBS that Main Street is the great beneficiary. We are better off with high-frequency trading than we are without it.” Bogle is more concerned with dark pools and the inherent instability of high-speed, high-tech trading. Referring to the Flash Crash of 2010, he said “all this technology is fragile … and can break down at a moment’s notice. There is a lot of stuff that’s going on behind the scenes that shouldn’t be going on.”
Writing for Reuters, John McCrank echoes Bogle’s concerns about the comparative risks of dark pools and argues that the increasing amount of trading that happens outside of exchanges may be a more serious threat to investors: The rise of “off-exchange trading” is terrible for the broader market because it reduces price transparency.
Kevin Drum argues that, whatever the arguments for or against the utility of high-frequency trading, what makes it so insidious is that it’s yet another way for Wall Street players to game the system in a way that’s so subtle it’s hardly noticeable -the kind of thing that permeates Wall Street. Drum thinks Lewis is correct to aim a spotlight at it.
Constraining high-frequency trading is no longer the purview of the CFTC and the SEC. Attorney General Eric Holder has announced that the Justice Department is investigating high-speed trading for possible insider trading, and the FBI has confirmed it has been conducting a wide-ranging investigation of high-speed trading for months, an outgrowth from the years-long crackdown on insider-trading.
Given all this intense scrutiny and debate, it came as no surprise when the high-frequency trading firm Virtu Financial decided to postpone its initial public offering, amid a storm of negative attention over its industry’s business model.