Flash Boys, Michael Lewis’ latest book is causing somewhat of a heated controversy. The book comes at a time when the FBI are investigating the possibility that so called High-Frequency Trading (HFT) is actually insider trading, except in this case it is not information about the stock but about the price that counts.
So what is HFT and are the allegations of market rigging that the book makes accurate or false? Also we consider how HFT firms are defending themselves in light of what appears to be an unfair market advantage.
What is High-Frequency Trading:
HFT is a computer-based system that sits inside the exchanges and provides liquidity to order flows by acting as a very temporary market maker between buyer and seller. It is important to understand, however, that HFT is not true market making. HFT firms do not take market risk; they do not hold positions at the end of the day, for example, or indeed for more than milliseconds. Their sole job is to provide liquidity to the markets for an infinitesimally small fee. Whilst this may all sound good there is a catch – a big catch.
What‘s the catch?
As Lewis points out in his book these firms make constant profits. The example he cites for one HFT firm is a thousand days in a row. Anyone who has sat on a trading desk will know that this kind of a record is not possible unless the trader has some kind of an edge over everyone else.
The HFT edge is that the HFT firms are buying the order flow or the right to transact the trades from online brokers, banks and other financial intermediaries. What they are then alleged to be doing is to “front run” those orders knowing precisely what the orders are. This is done literally in a matter of milliseconds by computers with no human intervention.
There are several contentious issues with this takeover of the world’s financial markets by computers.
Firstly, because it is a systematic but opaque transaction cost it increases, infinitesimally, the cost of each trade.
Secondly, because the cost is not disclosed it is legitimate for investors to ask why not, and why are the HFT firms so secretive about their operations.
Thirdly, there is a legitimate question to ask; to what extent is the front running of trades actually systematic insider trading but based on price information rather than news? In other words not only is front running illegal but doing so on inside information doubly so.
Irrespective of the positives that HFT may provide such as liquidity, these are questions that must be answered if the implicit faith investors place in financial markets is not to be rocked again. A stock market is merely a place for matching buyers and sellers. It is a place where buyers and sellers have a right to know what price they are really paying or selling an asset for.
So called Dark Pools, which are markets outside the listed markets are similarly questionable because they take price transparency away from the market to off market sites where the reporting of transactions is delayed to the primary market, thus taking the ability of an investor to see how the market is truly pricing a share.
A two-tier market:
What HFT and Dark Pools have done is to introduce a two-tier market, where one group has a distinct advantage over another. In the case of the HFT the advantage is in knowing what is going to happen next, just before a trade is executed allowing the HFT to benefit at the expense of the buyer. As far as Dark Pools are concerned the advantage to the brokers is due because these off market exchanges allow for buyers and sellers to be kept apart.
Why would brokers want that? Well it speaks for itself the more opaque the price information, and the further apart buyers and sellers are from each other the more chance for broker or intermediation profits.
Does it really matter? For an investor, in other words anyone that takes a longer-term view, the answer is that it really does not matter from a pricing perspective. The amounts are so small that they are virtually unnoticeable. What cannot be ignored though is that the systematic nature of HFT questions financial market integrity. It is absolutely in the interest of every investor to expect that the markets are transparent and that there is not a system in place to profit from their every transaction that is not fully disclosed.
Surprise, surprise
If the allegations prove to be true, and there appears to be substantial evidence supporting the case, and if the authorities move to correct the practice then it could cost Wall Street billions in lost revenues. Wall St banking and financial markets simply cannot afford to have another case of market abuse brought against them that is legitimate and proves that the insiders are playing a game with the odds weighted in their favour. The only surprise, given that the practice is well established, is that people are surprised.
As Lewis explains, the current situation is analogous to a casino setting up a card game with two card professionals. The casino asks the players to make it look like a good game, and tells them that the card deck is missing an 8, 10 and a Queen and their suits. Only the professionals know this. The casino then pays travel operators to bring in the unsuspecting punters to play a loaded game, which they cannot hope to win over time. How long would you continue to play at that table knowing the above?
The HFT defense is that they provide the market with much needed liquidity. But CheckRisk is skeptical. HFT’s do provide liquidity under normal market conditions, however, when market volatility spikes that liquidity vanishes. They simply cannot trade quickly enough and so it becomes like standing in front of a train. HFT’s at this point simply step off the tracks and wait for things to cool down.
