"The United States stock market, the most iconic market in global capitalism, is rigged." So says author Michael Lewis in his new book about Wall Street (and in the most quotable part of his recent 60 Minutes segment.) But defenders of that market are fighting back, creating the hottest debate in financial circles this week.
In his new book Flash Boys, featured on 60 Minutes on Sunday and excerpted in The New York Times magazine this week, Lewis highlighted what he thinks is the most dangerous affliction on Wall Street: the scammy-sounding practice of high-frequency trading (HFTs). As the name suggests, HFT relies on super-fast computers, high-speed data networks, and complex algorithms to make a lot of money in the stock market, simply by beating the other guy to the punch. HFT systems can make millions of dollars worth of trades in the blink of an eye and without a human being lifting a finger. The difference in speed is in milliseconds, and fractions of milliseconds, but that can mean the difference of millions of dollars to firms that do it well.
Lewis singles out one specific advantage available to high-frequency trading, an ethically dubious strategy called "front-running." When a large bank, hedge fund, or other institutional investor decides they want to execute a trade, they place an order for a certain amount of stock at a certain price, and send that order out to various stock exchanges via computer networks. When companies that are equipped to do high-frequency trading receive that order, they (or their computers) recognize that a certain stock is about to be purchased in large quantities. So in the split-second before the order is filled they start buying up the stock. By "front running" the order, they can drive up the price of that stock, forcing the company placing the original order to pay more than they otherwise would have. The whole process is automated and takes just milliseconds, but do it enough times, with enough stock shares, over a long enough period, and it really starts to add up.
"They're able to identify your desire to buy shares in Microsoft and buy them in front of and sell them back to you at a higher price," Lewis explains. 60 Minutes likened the practice to a family of four deciding to buy four tickets to a sporting event for $20 each. But after hitting the Buy button, only two tickets are bought, and the other two now cost $25. A "skim," 60 Minutes called it. A totally legal one, too.
Predictably, the story that high-frequency traders are cutting the line to steal profits from hard working investors has caused considerable outrage. Less than 24 hours after the 60 Minutes piece aired, the FBI announced they've been working on a year-long investigation into the practice. SEC commissioner Daniel Gallagher is also trying to step in to do something. “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 said to CNBC. “That perception to me is a reality. It’s something we need to address.”
But is it really unfair? No one denies that front running is a real consequence of HFT, but that practice has plenty of supporters on Wall Street who argue that it actually makes markets more fair. Modern Markets Initiative, an HFT advocacy group, went on a tweeting rampage after the Lewis story aired, promoting the work some HFTs do. To them, the benefit of faster trades, controlled by computer programs, is obvious: they make the market more efficient.
"Professional traders use technology when competing with each other to give investors the low cost liquidity and fair prices that they need," Modern Markets Initiative's Peter Nabicht said, as highlighted by Politico's Playbook. Some companies have developed computers and programs that work faster than others, which on the whole makes the market react more efficiently to relevant, live news. HFT allows price corrections to happen more quickly and with less guesswork.
Matt Levine at Bloomberg View also defends HFT on the grounds that it cuts down on the human element. Large, smart firms have always had an advantage over the little guy because they had better information, but HFT whittles down that advantage by reacting faster to changing conditions:
There are two ways of characterizing high frequency trading. In one, HFTs are front-running big investors, rigging the game against them and making the stock market illusory. In the other, HFTs are reacting instantly to demand, avoiding being picked off by informed investors and making the stock market more efficient.
Mark Buchanan, also writing for Bloomberg View, highlights research that explains this efficiency more clearly. He imagines a case in which bad weather causes the raw materials that make up soft drinks to become more expensive. The stock for a big name like Coca-Cola would go down immediately (because everyone knows they are a huge player in the industry that will be hurt by the news), but lesser-known soft drink companies would take longer to decrease. This meant that the market wasn't in sync with itself. "Back in 2000, it took several minutes for a price change in one security to be followed by a similar price change in other related securities," Buchanan writes, citing research from Oxford University finance expert Austin Gerig. "Now, with the advent of high-frequency trading, it happens in less than 10 seconds." That quick trading speed keeps the market in tune.
In addition, automated HFTs make up the majority of stock market trades and thus put more activity and liquidity into the market. As Forbes contributor Tim Worstall notes, that liquidity lowers the market's "spread" — that is, the price difference between how much a stock costs to sell and how much it costs to buy. A lower spread as caused by high-frequency trading therefore makes individual trades less costly for the average stock-user. "So I’m afraid that Lewis has got this the wrong way around," Worstall writes. "The HFT guys are making money, … [but] in much smaller sums than the general investors in aggregate are saving through the collapse in spreads as a result of the extra liquidity." That skim off the top is just the price to pay for a more efficient system overall.
The financial blogger known as Kid Dynamite concurs. It's actually the big powerful Wall Street firms who have the most lose from HFT front-runners, and since when should anyone feel sorry for Goldman Sachs?
There is this repeated claim that we need to “level the playing field for the little guy.” Hogwash – the little guy is the *beneficiary* of most high frequency trading activity! [...] The *losers*, then, are the big boys – traders executing big orders who leave big footprints. They have to be much more careful, and face competition from high frequency traders.
Those with skin in the HFT game were particularly loud in their rejection of Lewis' conclusion, such as BATs Global Markets president William O’Brien in an interview with Marketwatch. "Greater use of technology has allowed a significant reduction of risk in the market over the last 10 years, because firms are using technology capital (rather than their balance sheet) to manage their risk," O'Brien said. Seeing Lewis and other market companies vilify HFTs was, to O'Brien, like if "GM wants to write a book saying it’s unfair for the automotive industry that Elon Musk created a new car," he added.
It was O'Brien who challenged Lewis and trader Brad Katsuyama (the hero of Lewis' new book) on CNBC on Tuesday, leading to a heated and compelling TV segment. He accused Lewis of essentially doing a "300-hundred-page commercial" for Katsuyama's company, an alternative stock exchange called IEX, that promises to eliminate the advantages of HFT. O'Brien is angry that their fear-mongering will drive average investors out of the market.
Ultimately, what it comes down is what your definition of a "fair market" is. Lewis argues that the game is rigged in favor of the big guys with the fastest computers. HFT proponents say the game has always been "rigged" in favor of those with the most money and the best information, but it's the computers (and the math) that will slice down that advantage and ultimately make investing safer. "None of this means that high-frequency trading is an unmitigated good," Buchanan writes. But it's not as obviously evil as Lewis and 60 Minutes made it out to be.