Editor note: There's also a a good complement to this post: Do You Think The Market is Rigged
For the last year Michael Lewis, the writer of the Big Short, has been writing his new book Flashboys. Flashboys discusses the topic of High frequency trading, a topic that has been a hot issue in the markets for the past 5 years.
In an article by Bloomberg Michael Lewis questions HFT and says,
While speed traders’ strategies, developed over the past decade with help from exchanges, are legal, “it’s just nuts” that they’re allowed, Lewis said during an interview televised yesterday on CBS Corp.’s “60 Minutes.” The tactics are too complicated for individual investors to understand, he said. The United States stock market, the most iconic market in global capitalism, is rigged. It’s crazy that it’s legal for some people to get advance news on prices and what investors are doing.
Not everyone says speed trading is unfair. Peter Naybricht disagrees and says that,
“While there are bad actors in every industry, the game is not rigged in the favor of professional traders who employ HFT to execute their strategies. Rather, they work hard to compete with each other to bring liquidity to the markets, benefiting average investors,” he added. “Continued debate about the next evolution of market structure is needed and welcome, provided the debate is based on fact and resulting actions are reasoned, ensuring average investors continue to benefit from the transparency and efficiency enabled by inevitable technological advances.”
Federal investigators have started to stick their noses into the issue of HFT and have argued that they are concerned that HFT detracts from the fairness in the market place and that
The problem with high-frequency trading right now is that there’s a perception that for the little guy, the markets aren’t fair, Gallagher told CNBC during an interview. That perception to me is a reality. It’s something we need to address.
Although I wouldn't call myself an expert, I feel that HFT has taken a lot of unwarranted criticism. I've noticed many people are finding a place to shift blame for the difficult market environment that has been present since the crash. However, I don't work in trading, or a public markets role, and I haven't seen firsthand movements that have affected investment, so I wouldn't know. However, when federal investigators say things like
the problem with high-frequency trading right now is that there’s a perception that for the little guy, the markets aren’t fairI start to question the argument against it. Is it really fair to say that HFT alone makes the market unfair?
Up until very recently brokers and market makers made HUGE profits at the expense of investors in order to help securities change hands, and HFT seems to be a more efficient, and cheaper way to do it. That's not to say that there are issues with it that need to be sorted out, but if you look at it from a perspective of past methods, there is definitely an argument for the cheap liquidity that it provides. Maybe the intricacies of High frequency trading, discussed by Michael, will change my mind.
What do you guys think? Is HFT something that needs to be regulated, because it ruins the markets? or do you think that the people who call it "unfair" are simply behind the curve, and not accepting of change. Are the markets "rigged"?
More information on Flyboys can be found here
Even though I agree with the benefit of "bringing liquidity to the market," I'd be happy never, ever seeing that phrase again.
Vincent Viola is having a ball. The book is worth reading.
The speed of light is 200 miles per millisecond.
We can move to a system that is fair to people running python scripts at home, but the second it's quicker to send an order from New York to the Cayman Islands than it is to get execution on the NYSE, there's going to be regulatory arbitrage.
The conservative route for the SEC and regulators isn't to have frequent batch auctions every second, but to have frequent batch auctions every millisecond or every five milliseconds.
Update: The FBI is investigating http://online.wsj.com/news/articles/SB100014240527023048869045794738741…
It seems that Lewis has done a good job of reigniting the conversation about HFT. Probably good for book sales.
Didn't read the book yet, but here's a good critical response: http://blogs.reuters.com/felix-salmon/2014/03/31/michael-lewiss-flawed-…
I like the fact that you have yet to read the book, however you did find a critical response persuasive enough to post it.
If you read the article, you'd realize that you don't have to read the book to understand his critique.
Incidentally, I like how you think you're able to understand my reservations on the matter from my post which I regard as a "good critical response", given the fact that the source is from one of the most highly respected members of the financial/economic commentariat available.
Everyone talks about harming the "little guy", but I haven't seen anyone define who that really is. Are we talking about someone like my dad who has his 401k and IRA? Or are we talking about small day traders? Or are we saying that the independent CFA with $10MM AUM is the little guy?
And, if HFT is really harmful to these "little people" how? The fact that they cannot participate is not in and of itself harmful. In fact, I would say that the skill set needed to create effective algorithms for HFT would exclude most of these "little guys" anyway AND to the benefit of their portfolios as they wouldn't be able to trade quickly enough to take advantage.
Just my opinion. I hate the "Little Guy" archetype that people trot out as an excuse to not do something without explaining why.
I don't necessarily have an opinion on HFT, but technology has also improved the prices we pay. Look at bid/ask spreads and trading fees since online trading became so prevalent. Gone are the days where an investor has to shell out huge fees to a broker to initiate trades. Just pointing that out.
And +1 @"Scott Irish" for that comment. To me that phrase is just as cringeworthy as "But the markets/valuations are different this time."
http://www.cnbc.com/id/101544772
that was fun
This is hilarious: http://finance.yahoo.com/news/watch-fight-stopped-trading-nyse-17384078…
The question is does this play into the hands of the banks? (GS were quick to back Brad)
Lewis' interview with 60 seconds: http://www.cbsnews.com/news/is-the-us-stock-market-rigged/
The key complaint seems to be about scalping/ frontrunning, which is unfair and does in fact hurt anyone who trades. Ultimately, the damage to any individual is tiny (you won't notice it in your 401K). The people that really lose out are institutions that make big trades (e.g. hedge funds, buy side firms) and lose a few basis points or so on every share traded because its impossible to hide from the HFTs who will front-run the s*** out of it. If you're trading $40B a year that money adds up, though it will obviously be dwarfed by your own speculative gains (or losses)
Exactly, and my problem with the "critical" response is trying to defend the scalping by saying oh what does it matter it doesnt hurt the average mom and pops, and that it also only hurt day traders (Im not day trader) if you try to to find the next google, the next apple and if you are value investor you could care less. but I dont find that to be sufficient defense against the scalping/frontrunning.
But of course the HFT market makers aren't "front-running" anything, they are integrating the information of public order flow. Institutional investors are free to use dark pools and avoid such information leakage, but they will of course pay wider spreads to do so. Moreover, they could simply invest in the equity of HFT market makers and have their "stolen cost-basis" returned to them through dividend checks.
By what authority do you get to dictate who keeps the couple pennies per share changing hands as institutional investors roll their portfolios? Why should we be inspired to arbitrarily hand those pennies to institutional investors, rather than having the HFT market makers price in that information and transfer the benefits to the broader market in the form of narrower spreads?
You could effectively front-run by quote stuffing (funny it is exactly what messed BATS' IPO up), given that by rerouting to dark pools you're not exactly promoting market transparency (law of unintended consequences).
@"dazedmonk" - Great comment showing both sides... +1 SB
Agreed that HFTs are not vital to the market, but at the same time they are just doing what every broker has done since the start of markets.......theyre taking a spread. HFTs were one of the driving forces behind the automation of exchanges and the decimalization of prices to narrow spreads (both of which i think most people would agree has made the market more efficient and opened it to a broader range of investors). Now were going to penalize these people for finding a more efficient way to make a spread (i.e. dont assume any risk by flipping the position instantly and still take the spread)? It just doesnt seem right at first glance.
Yes they do: dark pools. By executing via dark pool, institutional investors can pay a wider spread to enjoy the benefits of opaque orders. That is precisely the product that IEX is offering and which Lewis ostensibly supports.
You're twisting words here. HFT market makers offer a perfectly substitutable good, viz., order execution. They charge narrower spreads than do traditional market makers, which is saving, not costing the broader market.
Lewis' sympathetic party here is institutional investors who are used to being able to pick off pennies from less informed liquidity providers before the impact of their orders is priced in by the market. Read closely: the broader market used to be paying these pennies to institutional investors via wider spreads because of mispriced executions (market makers committing mistakes, in my suggested language above). In that environment, you and I (broader market) pays wider spreads to compensate market makers for the risk of trading against more informed counterparties (institutional investors). That is a cost borne by the broader market, paid to market makers, with the net benefits being enjoyed by institutional investors.
HFT's have arbitraged most of these execution imperfections away. Today, the broader market enjoys narrower spreads, paid to market makers, and institutional investors no longer enjoy their free pennies. To emphasize: the broader market benefits. And since HFT is a competitive business, firms compete against one another to further reduce spreads, meaning that the total cost of these execution frictions has been reduced over time.
They are not given any information that is not also available to other registered market makers, they simply pay to have their computers positioned more closely to the source of the information. All of their "advantages" are enjoyed at a cost; you are free to assume that cost to enjoy the same benefits. There is nothing "unfair" about that.
This "rent seeker" terminology is just inane. Market participants have always been willing to pay a spread to market makers for the benefit of liquid execution. If you want to call that a "rent" (which to me serves no purpose other than adding a rhetorically-charged connotation to the activity), be my guest. But the point remains: HFT firms have reduced that "rent" considerably in a very short period of time. If you oppose "rent seeking" behavior, you should be the biggest champion of HFT proliferation, not a challenger.
As for being free to "block" those tools, of course! So long as their methods of "blocking" don't entail having arbitrarily favorable government regulations passed. If the exchanges want to change their policy, more power to them. If Lewis' rockstar commands all of the institutional order flow, I support his endeavor. But the only true "rent seeking" (since you've introduced the term) here is being done by those trying to have the government protect their profits against more savvy competitors.
Harming the "little guy" is the new version of "what about the children".
Why are we worrying about idiots in the market day trading or whatever. The vast majority of individuals should be in low cost mutual funds and dollar cost average. Just invest a certain amount on a certain time and you are fine.
Usually when someone is shouting, screaming and cross-examining and interrupting thats a pretty good sign of desperation right there by the BATS guy.
Totally clicked the wrong button. I owe you a SB.
After reading the book, BATS is run for HFT by HFT, that guys salary is probably financed through proceeds from HFT firms, no wonder why he is mad.
The fundamental purpose of any stock exchange is to provide an easy means for companies to raise equity capital. To me HFT undermines this purpose. It's rent seeking on profits that are due to legitimate investors who have put own capital at risk into a venture in the hope of making a return. I don’t see how this can make a market more “efficient”, for lack of a better word, in promoting equity investment. The liquidity argument doesn’t sit with me, if anything prices have become more volatile and over-reactive to information flow, leading to less investment from legitimate sources as the risk/return trade-off is compromised. How can HFT possibly provide liquidity when the average holding time is a matter of seconds? The buyer and the seller are still there and will transact regardless, there's just an unnecessary middleman between them picking up the crumbs. The damage of HFT is not in the crumbs, it's the cookies that never get baked..
Your entire argument is undermined by the fact that spreads charged by market makers are presently at all-time lows, thanks in large part to HFT. If such technology is aimed at "rent seeking", they are truly doing a poor job at maintaining high rents!
In truth, HFT is not "rent seeking" in any way that traditional market making is not. And to the extent that such "rents" are reduced for the average investor, I can't see a legitimate argument against it. Forget all of this empty rhetoric about "liquidity" and "efficiency", which typically aim to misdirect; if we identify specific behavior and broad trends, it's very easy to identify that HFTs, far from "rigging" markets, have clawed away at the historical advantages enjoyed by institutional investors and, in so doing, reduced transaction spreads.
You cannot empirically prove that lower average spreads are a direct result of HFT, given variables involved. I would contend the vast majority of the reduction in spreads is simply thanks to technology facilitating increased information flow and general access to markets. But regardless, when HFT is involved between a buyer and seller, there is a value leakage to a third party which is not facilitating the trade. HFT is not a necessary component of financial markets so is therefore not market making. So when we're talking about trading profit which is riskless but not market making we are talking about one of two things - arbitrage or rent seeking. The difference is small but is important. Is HFT true arbitrage i.e. does it aide the dissemination of price information? Explain to me how an algo flooding the market with millions of fake orders just to incite a price reaction and then retracting those orders within milliseconds is relevant to the fundamental outcomes of a stock, or that a flash crash is indicative of true investor sentiment. Let's face it. Volatility is actively increased by HFT and the rewards due to investors for taking on this risk are systematically extracted by an automated computer program. I just fail to see how that could ever have a positive impact on the proper functioning of capital markets.
Just a note that is important as analyst HFT Firms revenues 7 Billion in 2009 and in 2014 1.3 Billion they are eating themselves in a very very small margin, they cant possibly survive.
Total HFT revenue? Why is this such a big deal then?
This is a little off-topic, but did anyone else feel like William O'Brien was a lot less mature and thoughtful in this video than he should have been?
I don't have an issue with the so-called 'front running' since it's not technically possible for the computer to pick up the information on the way to the exchange and place an order in front of it, so I'm thinking everyone that says 'front running' is talking about something else that I don't understand.
Fluttering, on the other hand, is something completely different. For those who don't know, it's when an HFT floods the market with buy/sell orders (20k+/second) with the express intention of creating latency on the system so they can get the extra millisecond of processing time before their competitors. This is similar to a denial of service attack and I am amazed that the exchanged allow it.
Someone mentioned entering orders with the goal of sparking a move in a certain way... that sounds like market manipulation.
Do these two tactics enhance market efficiencies? Absolutely not. We're not talking algorithmic trading- I have no qualms with you using an algorithm that trades every minute if you so choose... based on strategies, not exploiting the technological limitations of the market infrastructure. Huge, huge difference.
Now, realistically, I haven't been able to see any issues in terms of the way I trade/invest... I usually am in for several weeks, and this stuff seems to have less of an effect the longer the time-frame is.
Anyhow, take care all.
Also... @TheDiscountRate I was thinking that too. Every time he had a childish outburst I just thought to myself that he was NOT helping his cause. Not allowing the opposition to present their facts or 'facts', depending on your point of view, means you can't debunk them.
My favorite part was when he and Michael were discussing Michael trying to go to bats and they literally got into a "yes I did" "no you didn't" for like 30 seconds... I'm just saying, but... wow. well done my adolescent-acting friends.
I did think the funny part of the "yes I did, no you didn't" argument was when the O'Brien ask Lewis when he came by, and Lewis gives him an exact date. Hard to dispute such a quick response. But O'Brien looked like such a tool on the interview.
This is my similar to what I was thinking. And I actually didn't have anything against HF traders until O'Brien made himself look like Tucker Carlson. His aggressive defensive stance has made me start wondering..
While I don't necessarily think what HFT firms are doing is actually illegal, I do think that it is a manipulation of hypothetically (we all know they aren't) efficient markets to allow an algo to initiate fake orders, cancel them, then reap profits over a manipulated price. It may not be illegal now, but the gubment will probably change that. They are always a few years late trying to fix the markets. Their attempts to regulate will just encourage firms to figure out another way. It's inevitable. As a small time investor, I just look for value, appreciate lower spreads then previous years, and go about my way.
Has anyone actually mentioned that Scott Patterson put out a book before Lewis' essentially pointing out the same ideas but in less of a "critique" and more of a "here are the facts of HFT" kind of way. With all the talk of frontrunning and market manipulation personally i think there is some morsel of truth to it. Fluttering and a couple of the other techniques/order types that were created specifically by HFTs and essentially forced onto some of the exchanges probably need to be tweaked in order to facilitate a more "fair" senario for trading, but at the same time like others have said spreads are down and there are other options for trading if institutional and other investors feel they are being cheated (go to a dark pool and have a blast).
It seems like a lot of people are forgetting that this is a book and Michael Lewis is trying to sell them to make money for himself. Its a narrative that is probably skewed to one side to make it more appealing for everyday people to buy (a la Moneyball) and one side is always over represented otherwise its not a good book (read: any Malcolm Gladwell book stretching to make a point).
In any case i think we can all agree that the worst thing to do is probably to have any government agency look into it. Heres to a 12 year investigation that releases inconclusive findings once HFTs have moved onto something else.
@Scruff_McGruff - Yeah there is money to be made on both sides of the equation, but there is a lot of truth to the dangers of the regulators getting involved. They will apply all kinds of rules and laws that probably will not only avoid fixing the problem, but will surely make it worse. It's about to be election time, so I'm sure politicians are going to jump on it to "protect the consumer" even though insider trading was legal for legislators until recently.
I think that @"dazedmonk" and @"NorthSider" should go on CNBC and duke it out... this is getting interesting.
Loving the posts here. Very high quality. I actually went to watch Michael Lewis speak at a book signing the other night. He didn't really discuss anything technical but he talked about some of the characters in the book and some of the qualities of the people who are contrarians, and the qualities of people who are driven only by money, or prestige. Interesting discussion.
Not sure what's the problem here.
Not sure if posted, but here's a nice excerpt. I think it's a bit more realistic and informative than the logic exercises in previous posts.
http://www.nytimes.com/2014/04/06/magazine/flash-boys-michael-lewis.html
http://scottlocklin.wordpress.com/2014/04/04/michael-lewis-shilling-for…
What HFT is doing should definitely be illegal. Here's how it works:
Facts: 1. legally, trades must be executed based on the NBBO (national best bid/offer, which is essentially an amalgamation of all the exchanges' prices) 2. There are something like 13 exchanges in a 5-10 mile radius (can't remember the actual numbers)
HFTs see the order at the same time the first exchange does
HFTs then buy from the second exchange while the first exchange is busy checking other exchanges for prices
HFTs then resell on the second exchange to fill the initial order.
I won't get into the technical details, just understand that the three steps are roughly how it works.
Problems: There is zero liquidity added (note: all these shares were available to purchase already, they just front-ran the investor). Don't say they're a market maker or liquidity provider-- they're not.
There is zero efficiency added (the latency between NBBO and exchange quotes is not a mis-pricing... it's a technical limitation on the speed of electrons moving between the NBBO wire and exchange wires; HFTs operate based on the speed of light or microwaves, not electrons).
It harms price-discovery (they learn of the orders by putting out their own orders for the minimum size at a nearby price on every exchange-- when the exchange moves to execute, it withdraws every trade from the other exchanges. This means the supply/demand picture the investor sees is inaccurate, and since price is a function of the supply/demand function, the price is therefore inaccurate.)
It does not affect the spread: The spread is based on the risk of holding the security for the amount of time to find a buyer and the price-risk that goes along with the holding period (hence illiquid stocks have wider spreads while very liquid stocks have effectively zero spread). BUT: there is already a buyer and there is already a seller, meaning that there is no price-risk; the HFT just wandered into the middle of them, decided to take the money out of the buyers hand and put it in the sellers' hand (nice guys) then charges for the "service" (we can pretend they're all standing next to each other). An actual market maker give the seller his own money and AFTERWARDS finds a buyer-- the is the risk they're compensated for. Ok, now that I've beat that to death...
You can't just 'go to dark pools Why? Because dark pools are also filled with HFTs doing the exact same thing described above.
This hurts the "little guy": Let me define 'little guy': any individual with a retirement or pension fund, any institution that receives any money from an endowment (think: schools, non-profits, etc.). When people talk about how it only hurts big investors it drives me up a wall. Sherlock, I do believe the point of a mutual fund is to pool money from people that don't have enough to diversify themselves. By definition, the 'big investors' by and large are just the little guys banding together.
Hope that clears up a few things.
I think the theme here that we need to be promoting is democratic markets. Everyone should have roughly the same opportunity to trade and execute strategies. Democratic markets, which are not necessarily perfectly free markets (but are relatively close) promote economic growth and investor confidence.
The SEC needs to encourage a system where everyone pays a reasonable fee to get the same optimal execution of a strategy that is competitive with the HFT houses. I define reasonable as costing less than $500-$1000 per month for a base level of market access, plus whatever marginal costs are involved in a broader strategy.
This may mean requiring exchanges to throttle access for HFT firms.
We need to balance the evolution of ideas and trading strategies with the evolution of technology. Right now we have a great system for encouraging the evolution of technology, but it's not resulting in better markets- other than getting execution in half a millisecond rather than a millisecond, which arguably doesn't benefit humans. But if we can develop better trading strategies that provide more liquidity in a crisis, or stat arb strategies that do a better job of providing funding to more profitable firms, the economy grows more quickly.
The participation of HFT firms- and their competition with the banks and traditional market makers- is an indication of democratic markets. But the next step is to allow the average individual using open source technology to also participate in these markets. The better we can be at reducing the advantages of economies of scale, the more robust a market we will have.
Part of reducing economies of scale in HFT is allowing Congress and the SEC to have an agenda. Part of that agenda may involve speeding up the execution available to retail clients and part of that agenda may require a very modest throttling of HFT firms.
If the money is in execution, we'll get faster execution. If the money is in ideas, we'll get more robust markets that do a better job of managing the economy. I'm a programmer, I'd like to think I'm one of top ~20 Equity Vol developers on the street. I benefit from a gigantic arms race on the first option, but I prefer the second option. I prefer a democratic market that isn't concentrated and allows lots of different people to compete against the big boys. Part of having a democratic market is this idea that you can't get gigantic economies of scale on execution.
If you think insider trading should probably be illegal, you are someone who supports democratic markets over free markets. I don't like government intervention any more than the next guy, but there is a tension between democratic markets and free markets on HFT. I think that in this case, democratic markets should win over free markets. Everyone wins when market participants all believe the game is somewhat fair and people compete on ideas rather than execution or insider information.
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