Micheal Lewis’s new book, “Flash Boys”, (re)focuses the spotlight on the controversial practice of high-frequency trading (HFT) (original article):
Already, officials at the Federal Bureau of Investigation’s New York office are investigating whether such firms traded ahead of other players in the market, in what may amount to insider trading or other fraud, according to an agency spokesman. Regulators in Washington and in New York State have opened their own inquiries.
The worries are hardly new. Over the past five years or so, high-speed computers have increasingly taken over Wall Street, and trading has migrated from raucous trading floors in Lower Manhattan to far-flung electronic platforms.
Critics argue that Mr. Lewis broke no new ground (link inserted, not part of article). And a number of executives at the firms mentioned in the book said that Mr. Lewis did not double-check the facts.
High-frequency trading is almost impossible to avoid today. By some estimates, it accounts for half of all shares traded in the United States. Supporters argue that it has made the markets more efficient by creating a cadre of traders willing to buy or sell at any time.
Others are more skeptical. The New York attorney general, Eric T. Schneiderman, has put high-frequency trading on his list of top priorities. He seized the moment on Monday to discuss his yearlong investigation into the practice.
“Look, the problem here is — and I’m a fan of the markets, but I think Michael is right,” Mr. Schneiderman told Bloomberg Television. “We’ve lost a lot of credibility. A lot of investors do not have confidence in the markets and it’s up to those of us who believe in them, who enforce the law and regulate them, to restore that confidence.”
Mr. Narang, the [IEX] high-frequency trading executive, said he hoped the attention surrounding the book would quickly die down. He said that while he had turned down requests to appear on TV, he couldn’t help speaking out against the book.
“There’s no unfair advantage to using your brain, last time I checked, in a capitalist society,” he said.
Before I dive into this subject, what exactly is “high frequency trading“?
A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds. As of 2009, it is estimated more than 50% of exchange volume comes from high-frequency trading orders.
I again refer to a favorite source of mine, Keynes General Theory of Employment Interest and Money (Ch 12, Part V, #4):
“But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.
Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called “liquidity”. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.”
Now, take the “professional investor and speculator” out of the equation and replace them with a computer algorithm. Remove many of the financial sector regulations put in place after the Great Depression. Change the hypothetical thee month time horizon to fractions of a second.
In Keynes day, at least there was some work going into speculation (besides creating and refining an algorithm). If traditional investment is speculative, as Keynes suggests, we need a new word for high frequency trading.
The indisputable role the financial sector played in the financial crisis has shaken confidence in the financial system. Furthermore, the deregulation of commodities markets and subsequent commoditization of traditionally non-financial assets (food, fuel, housing, etc.) has left the “real economy” much more susceptible to fluctuations in financial markets / high frequency trading.
Therefore, it is not surprising that high frequency trading has garnered the attention of regulators. As New York attorney general Eric Schneiderman correctly states, it is the job of these regulators to restore confidence in a system that many see as a potentially destabilizing tool for the rich. There are undeniably positive aspects of financial services, but these positive aspects have been largely overshadowed by speculative and predatory practices.
We cannot wind back the clock on technology to stop high frequency trading. We can, however, curb the arbitrage / rent-seeking potential of high frequency trading with financial transaction taxation (FTT), reducing its prevalence. A FTT would raise tax revenues while also restoring confidence in financial markets (potentially without any negative impact on overall economic growth).