The release of acclaimed author Michael Lewis’ latest book yesterday has reignited the debate about high-frequency trading and the instant reaction from the HFT lobbyists would suggest they see Flash Boys as a serious threat to the sector.
The launch of the book by the journalist and author of Moneyball, Liar’s Poker, The Big Short and The Blind Side, complete with a US 60 Minutes segment and an excerpt in The New York Times Magazine, is unashamedly an attack on HFT and the traders, with Lewis telling 60 Minutes that US stock markets had been rigged by a combination of exchanges, Wall Street banks and high-frequency traders.
Debates about the impact of HFT on markets and investors have raged inconclusively ever since algorithmic trading first emerged, with its proponents arguing that it benefits investors, its critics claiming that it rips them off and the truth probably somewhere in between.
The central figure in Lewis’ book is a former Royal Bank of Canada head trader in New York, Brad Katsuyama, who said that when he would send larger orders to the market they would only be partially filled, leaving him to pay a higher price for the rest of the order.
Eventually he realised that his orders, transmitted through optical fibre lines, were reaching the closest exchange first. HFT traders would therefore see those orders and then, using their speed advantage (they are co-located with exchanges) would get to the other exchanges ahead of him, buying the shares he wanted and then selling them to him at a marginally higher price than his original order. All this, of course, occurs in milliseconds.
That’s a classic illustration of how HFT can work and explains why the traders spend significant amounts of money to gain micro-seconds of speed advantage.
There are traders who inundate a market with orders – again in micro-seconds -- that are instantly withdrawn simply to gain intelligence that enables them to ‘’front run’’ orders from ‘’real’’ investors.
Katsuyama eventually realised that by sending orders to the furthest exchange first and the closest last he could circumvent the HFT traders and fill his orders at his original price. He subsequently established his own trading platform on the basis of that realisation.
While there is no doubt that some HFT trading adds nothing to the markets and profits at the expense of retail and institutional investors, it is probably also the case that there are some forms of HFT that add liquidity to the markets and which also help narrow bid-offer spreads and therefore benefit investors by creating more efficient pricing.
It is instructive, however, that most of the big investment banks around the world have helped establish so-called ‘’dark pools’’ or private and opaque trading platforms largely to distance themselves from HFT – although Lewis’ book claims those pools have been infiltrated by HFT traders via ‘’hidden passages and trapdoors’’ and that the traders pay for secret connections to the pools.
If the most sophisticated players believe ‘’lit’’ markets are rigged and created dark pools in response, that might suggest HFT, or forms of it, are predatory in character.
A 2012 study by the chief economist of the Commodity Futures Trading Commission, Andrei Kirilenko, in conjunction with academics from Princeton and the University of Washington, concluded that HFT was highly profitable – in one month of 2010 traders in a single stock index futures contract made $US23 million – and that the returns-relative-to-risk for the traders were unusually high. Annualised, those profits from trading in a single contract would amount to about $US280 million.
The study also concluded that HFTs generated their profits from all other market participants; that the most profitable HFTs are those that are most aggressive in initiating trades and that have the fastest systems and that the most successful traders were liquidity-takers rather than liquidity-providers.
That would indicate that a large proportion of HFT activity profits at the expense of more traditional participants in markets, and that the trading the study looked at also detracts from market liquidity and equity.
There has long been discussion among regulators worldwide, including by the Australian Securities and Investment Commission, about how to respond to HFT. Last year ASIC moved to improve the transparency of dark pools and strengthened its ‘’manipulative trading’’ rules.
The regulators are concerned about the integrity and fairness of their markets, the cynicism among retail investors in particular about privileged position traders co-located in exchanges have over ordinary investors and the potential for market meltdowns like the 2010 ‘’flash crash’’ in the US which were caused by the impact of flaws in automated algorithmic trades.
The Lewis book will play to the cynicism of regulators and investors and has already sparked a new and intense debate about the merits, or otherwise, of HFT and the fairness, or otherwise, of co-location. That may or may not lead to further regulatory change but it is a good debate to maintain.