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Saw this on 60 Minutes last night. It's hard to believe that what Wall Street market exchanges are doing isn't illegal. But apparently it's not. Basically they, in an incomprehensible small time, milliseconds, can see what you are buying, buy it first and then sell it back to you for a profit. Even if the profit is pennies or fractions of pennies, they are skimming billions and making everyone else, including large brokerages and hedge funds, pay more for stocks.
Hopefully this publicity will cause enough outrage to put an end to the unfair practice. There must be enough influence by the Fidelity's and other huge brokerages to stop this stealing - you would think.
In the comments section, someone suggested a short-term tax. A tax of >50% on the gains made in less than a minute and also a substantial transaction tax for any round-trips done within seconds may work.
There is a bit of financial demagoguery going on. Hopefully, it results in some transparency and increased knowledge. The problem with HFT is not in "front-running" but what else happens around it. HFT isn't competing with common investors or mutual funds in the way it is portrayed here.
The key to understanding this is price discovery. Imagine a trade in very slow motion. Someone puts in a bid to buy a stock at $5 because he thinks it is fair value. Another puts in a bid to sell the same stock at $4 because he thinks that is a good price to get out for him. Now, is it fair to sell it at $5 or at $4? In either case, one of them got shortchanged given the buy/sell interest. This the basis of a market trade and a problem that needs to be solved.
One might say, buy at the lowest sell bid price or sell at the highest buy bid price. But that only works if a buyer publishes his bid and the seller doesn't or vice versa. So neither have an incentive to publish their bid. What happens if there are no buyers or sellers at a reasonable price at some point in time and some one wants to sell or buy and has no reasonable basis to bid?
You might say, each publishes their lowest and highest prices and sit on it until someone bites. The problem with this system is that the spreads become high and may diverge from the actual value of the share. We see this happen with thinly traded ETFs for example.
This problem existed long before electronic trading and was solved by using Market Makers. These are designated entities who put their own both buy and sell orders to provide a current floor and ceiling around the current price. They are not investors competing with regular investors but entities providing a financial service. Not unlike the spreads created by foreign exchange kiosks with a buy and sell price. These entities were allowed access to current investor bids to determine their bids.
These entities are risking money with their bids and they are not charities but they are not investing for stock appreciation but rather arbitraging the spread and do what might be called front-running, if they see an imbalance in bids. That is the price of the service offered to create price discovery not considered fixing the market. The effect of that arbitrage is to decrease the spreads and give orderly movements of the price up or down rather than a sequence of crashes. Investors tend to lose more without this system in place.
This human solution didn't scale to electronic trading and when the trading was moved to pennies than fractions, the returns for market makers became too low for them to provide that service. In addition, with multiple exchanges, real time spreads between exchanges became a problem.
It is incorrect to think that long term investing doesn't require instant price discovery. There are buyers and sellers at any instant whether they are investing for the long term or not. The fair pricing of assets for mutual fund transactions, for example, requires a "correct" price at all times even if all investors are investing for long term. Without efficient price discovery, there is no sensible investing possible without losing money to pricing inefficiencies.
The solution for the electronic world was to move this market maker arbitrage to traders themselves who would create that price discovery with their own bids. Again, these are not investors that compete with regular investors but help keep the price discovery efficient and get incentivized by the spreads. Faster the trading ability, more efficient the price discovery as the spreads are arbitraged away. Note that while they make a penny or two, it helps investors with a correct price rather than a stale price at any time.
The money made by these entities for this purpose is the cost of that service, not unlike the transaction fees by credit card companies for the credit card service they provide. As in a true free market solution, rather than select and designate market makers, anybody can become one by investing in the infrastructure to do fast trading. The competition keeps the spreads low.
So, the common objection to HFT as "front-running" or trading with an advantage over small investor is more demagoguery than reality because it caters to ignorance and prejudices.
That is the theory.
If you want to fix this, one ought to come up with another system for this that provides similar price discovery and equally scalable.
The problems with HFT are potential abuses of this access and the unintended or unexpected quantum effects as the decisions are made faster and faster relying on software that is prone to bugs and limitations. But that has nothing to do with this massive book related PR.
Have not yet read the book. Although I love most of Lewis' stuff (eg., Moneyball).
Just seems though to be same topic covered by Scott Patterson's Dark Pools, but by a more popular author. Not sure there is anything here that the financial community, including talking heads, have not been aware of and calling attention to for a few years now.
If HFTs have both preferential information and connectivity, hard to see how that combo does not facilitate front-running and undermine the markets. It does seem like latest manifestation of what has probably always existed in the markets, in one form or another, and probably always will...but that does not mean we should not rail against it (eg, Sarbanes–Oxley).
So, maybe Lewis will help...1000 hands on the wall.
Is there anything slower than the price discovery of a mutual fund daily price discovery (which I assume is referred to as the "daily NAV")? In today’s day and age, when a market is trading somewhere in the world (kind of like, "it's 5 o'clock somewhere"), don't mutual funds have a more difficult time determining their daily NAV? I have always thought a mutual fund NAV could be shaded during the day as well as after hours using something similar to FinViz color code. I try to approximate my mutual funds daily NAV by tracking an etf's price (i.e. SPY for VFINX) intraday.
I always wonder when my mutual fund manager actually executes its trades...very differently I would guess than when I decide to buy or sell shares of that mutual fund. Much of this buying and selling might even settle within the fund family itself under normal market conditions. Excessive selling by mutual fund owners must add a real challenge to fund managers. Are they waiting until the end of the day to act on these sell orders that queue up all day until 4 pm? Mutual funds with small AUM must really have to monitor their own in house accounts as well as outside trading platform that trade the funds.
In my way of thinking the high frequency trader is not a true market maker as they can turn their system off, or on, at anytime of their choosing where as a "true" market maker can not.
I have a provided a link to the definition of what a market maker truly is.
To me, the high frequency crowd is much like a ticket scalper for a sporting event as they scalp profits from selling the ticket above its fair value as sold by the event. In many states there are laws against scalping. Something to think on.
FWIW, and I admit it ain't worth nothin', I agree with Mr. Ritholtz on this one (and that is by no means always the case). My gut reaction whenever either Wall Street or Efficient Marketeers start talking about 'liquidity' is to hang onto my wallet. There's no doubt that in a perfect market liquidity must be absolute, that's just mathematics, and the closer to absolute it is the better, but in an imperfect market all the churning to which massive liquidity leads has the potential to magnify errors to disastrous proportions. They say that speed trading makes up half the trades in the stock market these days. Without it, spreads would be wider. I'd imagine that would make investors think a bit more before they traded. It would be terrible for Wall Street, but would it be so bad for investors? I have my doubts.
@old_skeet, the old concept of market makers isn't feasible any more in the electronic world of multiple exchanges.
If you read my post above, you will note that it is price discovery that is the key. Market makers did that earlier but their business model fell apart with small spreads. Staying in the market at all times is a separate issue for abnormal conditions and addressed further down.
HFT traders with access to bid data serve that particular purpose of price discovery by arbitraging spreads. Somebody has to do this and people in the media doing pop journalism aren't thinking of how this works wirhout HFT in their rants against HFT with very little understanding of how the markets work. It is a good litmus test for financial market literacy in the media.
Providing a stay in the market at all times function provided by Market Makers entails risk for them. They have to be compensated for it. The earlier bigger spreads justified it. You cannot force somebody to do it unless you either guarantee against loss or pay them enough to take that risk. Who is going to do it? Any way you do that, the cost will be borne by the investor transactions eventually.
However, that function can be eliminated if you can manage panic situations rather than designating somebody to take a loss in those situations. This is still work in progress as the few flash crashes prove it but eventually with enough circuit breakers and trading rules, you can make that function unnecessary minimizing panic induced disorderly selling. That is the better solution, so that the cost of a designated loss bearer service doesn't get folded into every transaction even in normal times
But all this misunderstood pop demagoguery is hiding the real problems inherent in this HFT based system. That we have a systemic risk created with increasing volume of HFT trading in that as pointed out liquidity can dry up instantly. This is not something you can prevent except by paying someone to guarantee it at all times but what you don't want is the system collapsing in such situations.
Currently, the system will come to a halt with no alternative price discovery if the HFT traders go away. So we have a "too big to fail system" of HFTs to get that price discovery. Just like the banks providing critical credit to economy, this gives leverage to the HFT traders to abuse the system. Rules to regulate the behavior runs the risk of driving them away from a critical function we need. This is the problem SEC has got until they can regulate the exchanges to remove this systemic risk. So, they are not in a position to do much, this pop book not withstanding.
The spread arbitrage which is what creates the price discovery isn't the "abuse". You don't need ticket scalpers for game tickets to determine a price. So the analogy doesnt hold.This arbitrage is what kept Market Makers in business earlier so this is nothing new and not specific to HFT.
The actual abuse comes from HFT not in arbitraging spread but in potentially creating FALSE price discovery based on the access to bid data. Even when there is a balanced market in bids with a tiny lower bid to buy than to sell until someone decides to move where there is no need to arbitrage, HFT traders can move the markets in a manipulative way with phantom bids, phantom trades, buying up sell inventory when they detect trending buy interest to drive the prices up. All this is legal for regular traders without using insider information.
But when HFT traders do this because of the access to bid data not available to other traders then you are allowing them to trade with the equivalent of " inside information". This is the type of trading that fits Ritholtz' phrase of "trading with no redeeming social value" though he doesn't seem to understand the nuances to differentiate this from bid arbitrage which does have a redeeming value of price discovery.
These are the kinds of things that need to be brought to light and regulated and hopefully this book will rise the awareness to pressure the SEC to come up with a mutual solution with HFT traders to prevent abuse that won't kill price discovery and bring the markets to a halt.
Even if the book is being used as a sawed off shotgun to fire indiscriminately at HFT trading without understanding how that might throw the baby with the bath water in this pop outrage.
The actual abuse comes from HFT not in arbitraging spread but in potentially creating FALSE price discovery based on the access to bid data. Even when there is a balanced market in bids with a tiny lower bid to buy than to sell until someone decides to move where there is no need to arbitrage, HFT traders can move the markets in a manipulative way with phantom bids, phantom trades, buying up sell inventory when they detect trending buy interest to drive the prices up. All this is legal for regular traders without using insider information.
But when HFT traders do this because of the access to bid data not available to other traders then you are allowing them to trade with the equivalent of "inside information". This is the type of trading that fits Ritholtz' phrase of "trading with no redeeming social value" though he doesn't seem to understand the nuances to differentiate this from bid arbitrage which does have a redeeming value of price discovery.
These are the kinds of things that need to be brought to light and regulated and hopefully this book will rise the awareness to pressure the SEC to come up with a mutual solution with HFT traders to prevent abuse that won't kill price discovery and bring the markets to a halt.
from michael lewis's fellow bloomberg opinion writer ( and former investment banker and a trained lawyer). i've read them both on numerous occasions, and if i had to choose by intellect, matt levine would get my vote. michael lewis is of course great at selling books.
Thanks fundalarm. I think Levine's article just reinforces the earlier views offered by cman: HFTs can be good for the market, but their preferential info and connectivity also provide opportunity to unethically exploit the market, which is not so good. I'm hopeful the recent attention will inspire regulators to revisit...make sure all is above board. Gotta believe the exchanges themselves are as culpable here as the HFT houses.
It is what it is. Unless the SEC decides to step in and force limitations or stoppage of HFT (and that seems unlikely, given the political clout of certain large firms that employ HFT), investors have to decide whether they will recognize the issue and still participate, or sit on the sidelines. It is possible a book (and a very unbalanced story on 60 Minutes) will lead to greater oversight in the areas Charles has mentioned, but I would not bet the farm on that happening. It is unlikely the story will cause much reaction, unlike the Meredith Whitney gaffe that caused panic in the muni bond market when so many people fell for her commentary. The HFT issue is much more complex. The biggest result will likely be the number of books sold, which like most investment tomes, will be out of date within a year or so.
@BobC, it isn't that simple. HFT disrupted the trading arms of the very large firms with the big political clout whose arbitrage opportunities declined reducing their profits.
If they had their way, they would have shut down HFT with their lobbying but there wasn't a way to do this and so they are forced to subscribe to HFT platforms. They still don't like it, not because HFT is apparently screwing the small investor but rather they are losing their arbitrage opportunities in the old fashioned way. They are definitely NOT lobbying SEC to keep HFT.
Ironically, SEC itself is paying for a HFT platform to monitor trading patterns for enforcement which might be another gripe the big boys may have against HFT as it exposes their techniques.
The lobbying of the HFT industry is very nascent and small in comparison.
Good coverage of this issue on CNBC today. Don't have the link for it but try to find the segment with Manoj Narang, a good example of the battle between the old and new, the traders and the nerds.
The segment with Michael Lewis was interesting as well. Michael is "talking his book", literally
The whole thing is an example of what happens when big money opportunities get threatened on either side.
I'm shocked that there's hanky panky going on in the world of high finance! I watched 60 minutes. Lewis strikes me as foremost a self promoter. I thought the segment on Elon Musk was much more enlightening.
How I see it: The U.S. has been pretty proactive in weeding out the slime. They don't always catch it in time, but at least there's a better effort in the states than most nations. What nations around the world do a better job? If you own an emerging market bond or stock fund, you're probably invested in Egypt, Russia, and Mexico. I'll hold the U.S. up against nations like that any time.
Perhaps Lewis should be commended under the theory that "sunlight is the best disinfectant." To that extent, he's performing a service. Still, something doesn't seem quite right the way he's out flogging his book on all the networks. And, am I going to call T Rowe Price and Dodge and Cox today and have them sell all my holdings cause the market's rigged? Are you kidding?
The debates on CNBC today regarding this are really some of the most heated/angry I've seen in quite some time. It's been a while since I've really watched CNBC and thought a fight was imminent.
Liked the response from Lewis to the vacant Sue Herera's question of whether or not this will result in further declines in investor trust: "Are you really under the illusion that the individual investor trusts Wall Street... the financial crisis wiped out any residue of trust for Wall Street even if they ever had it."
Hi cman. Thanks for your response. I certainly did not intend to imply anything about the HFT issue is simple, rather to say that individual investors (as has been pointed out quite often) have very limited recourse. If they can dig through public information, the may decide to not do business with firms who participate in HFT (although the definition of HFT varies a lot depending on who is responding to the question). Other than that, as I pointed out, there is not a whole lot investors can do, except sit on the sidelines or understand HFT is out there and that this can have a dramatic impact on volatility. On the other hand, the SEC (and FINRA) are doing a great disservice to investors, advisors and member companies by not taking a pre-emptive stand. But do not kid yourself that politics are not involved somewhere. This administration has jumped in with both feet where lower-risk issues were involved for investors. So this one is a puzzle.
The more I read the debates on this, the more it starts to resemble the common knee-jerk reaction to the acronym GMO in foods. Lots of opinions that the concept whatever it means is bad but very little specifics or knowledge on why exactly it is bad and in what contexts. It is just based on a passuve acceptance of a narrative that it is bad.
@BobC, it is puzzling if you accept a premise that HFT is bad and so since SEC has not done something about it, there must be lobbying noney behind it. After all who looks after the small investor, but in any case since a lot of things have been done recently to protect the small guy, it is puzzling to see nothing done in this case. It is a self-created puzzle.
A moment's reflection will show that this logic is entirely based on the premise itself. The puzzling aspect disappears if the premise is wrong or too generalized to be actionable. Just ban HFT has as much hysteria as just ban GMO without understanding all the applications many of which is no different from what people did for decades except it wasn't done as an industrial solution.
For example, what exactly about HFT is wrong? This is what SEC needs to decide. Is it the fast execution speed some people have? The speed differential has always been there that was exploited by major traders before and the big spreads hurt the small guy much more in that case. HFT just happens to be in millisecond differentials. So there is no reason to ban it for that reason.
SEC doesn't ban things because some people think there is no need for it in their world even if they cannot pinpoint why they are uncomfortable with it and just buy into a narrative. If that was the case, we wouldn't have mobile phones.
One can go through a list in similar fashion. Is it the ability to buy at a cheaper exchange to fill an order at another exchange. This kind of arbitrage happens all the time just in much slower time for example in currency or commodities trading and actually helps reduce the spread between various locations say for example in physical Gold or Oil. The people who have the infrastructure to take physical delivery in two different locations are in a position to exploit that over people that can only take delivery in one location. The advantage comes from investing in that infrastructure. It is a valid basis for trading.
Is it the preferential access to data? There has been such preferential access based on ability to pay all the time. Do small investors get the same access to data that institutional investors do? No. Do the institutional investors get the same timely access to data that a client of GS or JPM does if they don't pay for it? No.
When SEC looks at things at this level just as FDA does regarding GMO, they might come to the same conclusion. That there is no reason to just ban it. But it is reasonable for them to look at some aspects of it to see if it is harmful.
This is not to say there aren't potential problems with it especially if it can be abused to break EXISTING laws, just as GMO can be abused. But the demogoguing reasons used against them are easier to bite into for an average person than the actual details. But SEC (and FDA) cannot do that. And that creates theories of conspiracy, corruption, etc. It is natural.
I am glad to see people like the one in the article linked by @davidmoran above start to question the popular demagoguery and provide a critique of that book. Even the Bible has its critics pointing out flaws! I see the reaction from David to such articles to be the same as the reactions from people to articles that try to look at good and bad of GMO than join the mob crying for a blanket ban.
I like Michael Lewis but in this one he appears to have over-reached for popular appeal. Perhaps, he always did that and I didn't notice it before because it confirmed my biases on those topics.
cman's comment on the likelihood of a misinformed public is very common today. I'll add "Climate Change" and "Autism" to that list. Most of these opinions are based on misinformation and emotion. I think it's human nature to form opinions quickly even if they are initially incorrect. The challenge is digging deeper (educate yourself) and reveal the true nature of the problem and hopefully design actionable solutions.
When it comes to the GMO debate I like to remind people how much starvation existed in the world due to a host of problems associated with growing food. To better understand the science (the facts) and engineering (the problem solving) that brought about GMOs I would suggest reader familiarize themselves the "The Man Who Fed the World", Norm Borlaug.
Not withstanding Ecclesiastes 9:11, in some instances the race often does go to the swiftest. Timely decision making and committed execution are primary assets in the investment universe.
Over the last week nothing much has changed in that investment world except that Michael Lewis’ book “Flash Boys” is now receiving wide publicity. The book is new; High Frequency Trading (HFT) is not. We have just been made more aware of its pervasiveness.
Being early into the marketplace is surely not a novel concept. The Rothschilds used carrier pigeons to secure a time advantage in the 17th century. Jesse Livermore practiced it all the time, and after he gained renown as a heavyweight stock plunger, he needed methods and ploys to disguise his intentions. Copycats have always existed. Today, the mutual fund houses (like Fidelity) deploy more sophisticate tactics to the same end.
The issue of HFT was ushered into the investing community with the development and introduction of computers into the financial marketplace in the 1970s. Decision making and execution speed have always been a powerful weapon in the professional investor’s weapon arsenal.
Algorithmic trading and HFT have been part of the investing environment since the 1980s. Like it or not, a tested and verified algorithm doesn’t take long to evaluate a dynamic evolving situation, and doesn’t make errors in execution. So it consistently generates superior outcomes than when a human being is in the loop. HFT became common in the late 1990s, and dominated the trading volume by the mid-2000s. In 2009, it is reported that HFT constituted roughly 70% of the daily trading volume.
I’m sure you guys remember the stories a few years ago that touted these HFT houses who located a few miles closer to the North New Jersey market computer facilities to benefit from a reduced hard-wire access physical distance. Now that’s really working hard to establish a microsecond trading advantage.
Recall the 1987 stock market crash. The most likely causes for that dire event were the popular use of the Black-Scholes Option Pricing model and the overused Portfolio Insurance concept. The primary causes for this fiasco are still debated however. Another example is that, after much detailed study, the May, 2010 Flash Crash was finally attributed to the HFT cadre. Recovery was all within a one day timeframe in that instance.
So far, recoveries seem to have been rapid, and the impact of HFT on a private investor’s end wealth seems limited; my zeal for the equity marketplace is not quenched by this disclosure.
One indisputable benefit from all this computer technology is that trading costs have been substantially lowered. I remember the excessive costs I begrudgingly accepted in the mid-1950s when I bought my first stock. Wow, the price to play was huge.
Are these HFT outfits gaming the system? Yes, but historically there have been financial adventurers who have always played in that dark arena. The SEC rules committee diligently tries to minimize their impact, but clever stock operators find and exploit loopholes. However, from a personal perspective, I suspect the money drains from these operations have little impact for my buy-and-hold style of mutual fund market participation.
So, I don’t get too exercised over Lewis’ new book. The book reviews suggest that the presentation is very asymmetrical; it is not a balanced research project. It has an agenda. At some point I will read it, but I feel that I need not rush.
Based on an aroused public, I’m sure one outcome from its release will be that various government agencies will expedite investigative efforts which have been under way for several years now. That’s goodness. Some rules loopholes will be closed, but just as night follows day, new loopholes will be discovered. As a group, investment professionals are forever searching for an exploitable edge, and they find it.
None of this dampens my enthusiasm for the US marketplace. It remains basically a fair game for small time investors. It is one of the few investment opportunities that offer a high likelihood of outdistancing the erosive effects of inflation. I’m more or less sanguine over the Lewis revelation.
I want to congratulate all the MFO contributors to this excellent exchange. Your diverse and carefully documented positions on this matter really added needed depth to the continuing HFT discussion. Thank you all.
Comments
Regards,
Ted
https://www.google.com/#q=michael+lewis
Hopefully this publicity will cause enough outrage to put an end to the unfair practice. There must be enough influence by the Fidelity's and other huge brokerages to stop this stealing - you would think.
Summary: .................As the lobbyist strolls into the Halls of Congress...............
The key to understanding this is price discovery. Imagine a trade in very slow motion. Someone puts in a bid to buy a stock at $5 because he thinks it is fair value. Another puts in a bid to sell the same stock at $4 because he thinks that is a good price to get out for him. Now, is it fair to sell it at $5 or at $4? In either case, one of them got shortchanged given the buy/sell interest. This the basis of a market trade and a problem that needs to be solved.
One might say, buy at the lowest sell bid price or sell at the highest buy bid price. But that only works if a buyer publishes his bid and the seller doesn't or vice versa. So neither have an incentive to publish their bid. What happens if there are no buyers or sellers at a reasonable price at some point in time and some one wants to sell or buy and has no reasonable basis to bid?
You might say, each publishes their lowest and highest prices and sit on it until someone bites. The problem with this system is that the spreads become high and may diverge from the actual value of the share. We see this happen with thinly traded ETFs for example.
This problem existed long before electronic trading and was solved by using Market Makers. These are designated entities who put their own both buy and sell orders to provide a current floor and ceiling around the current price. They are not investors competing with regular investors but entities providing a financial service. Not unlike the spreads created by foreign exchange kiosks with a buy and sell price. These entities were allowed access to current investor bids to determine their bids.
These entities are risking money with their bids and they are not charities but they are not investing for stock appreciation but rather arbitraging the spread and do what might be called front-running, if they see an imbalance in bids. That is the price of the service offered to create price discovery not considered fixing the market. The effect of that arbitrage is to decrease the spreads and give orderly movements of the price up or down rather than a sequence of crashes. Investors tend to lose more without this system in place.
This human solution didn't scale to electronic trading and when the trading was moved to pennies than fractions, the returns for market makers became too low for them to provide that service. In addition, with multiple exchanges, real time spreads between exchanges became a problem.
It is incorrect to think that long term investing doesn't require instant price discovery. There are buyers and sellers at any instant whether they are investing for the long term or not. The fair pricing of assets for mutual fund transactions, for example, requires a "correct" price at all times even if all investors are investing for long term. Without efficient price discovery, there is no sensible investing possible without losing money to pricing inefficiencies.
The solution for the electronic world was to move this market maker arbitrage to traders themselves who would create that price discovery with their own bids. Again, these are not investors that compete with regular investors but help keep the price discovery efficient and get incentivized by the spreads. Faster the trading ability, more efficient the price discovery as the spreads are arbitraged away. Note that while they make a penny or two, it helps investors with a correct price rather than a stale price at any time.
The money made by these entities for this purpose is the cost of that service, not unlike the transaction fees by credit card companies for the credit card service they provide. As in a true free market solution, rather than select and designate market makers, anybody can become one by investing in the infrastructure to do fast trading. The competition keeps the spreads low.
So, the common objection to HFT as "front-running" or trading with an advantage over small investor is more demagoguery than reality because it caters to ignorance and prejudices.
That is the theory.
If you want to fix this, one ought to come up with another system for this that provides similar price discovery and equally scalable.
The problems with HFT are potential abuses of this access and the unintended or unexpected quantum effects as the decisions are made faster and faster relying on software that is prone to bugs and limitations. But that has nothing to do with this massive book related PR.
Have not yet read the book. Although I love most of Lewis' stuff (eg., Moneyball).
Just seems though to be same topic covered by Scott Patterson's Dark Pools, but by a more popular author. Not sure there is anything here that the financial community, including talking heads, have not been aware of and calling attention to for a few years now.
If HFTs have both preferential information and connectivity, hard to see how that combo does not facilitate front-running and undermine the markets. It does seem like latest manifestation of what has probably always existed in the markets, in one form or another, and probably always will...but that does not mean we should not rail against it (eg, Sarbanes–Oxley).
So, maybe Lewis will help...1000 hands on the wall.
you can send it to CBS.
Is there anything slower than the price discovery of a mutual fund daily price discovery (which I assume is referred to as the "daily NAV")? In today’s day and age, when a market is trading somewhere in the world (kind of like, "it's 5 o'clock somewhere"), don't mutual funds have a more difficult time determining their daily NAV? I have always thought a mutual fund NAV could be shaded during the day as well as after hours using something similar to FinViz color code. I try to approximate my mutual funds daily NAV by tracking an etf's price (i.e. SPY for VFINX) intraday.
I always wonder when my mutual fund manager actually executes its trades...very differently I would guess than when I decide to buy or sell shares of that mutual fund. Much of this buying and selling might even settle within the fund family itself under normal market conditions. Excessive selling by mutual fund owners must add a real challenge to fund managers. Are they waiting until the end of the day to act on these sell orders that queue up all day until 4 pm? Mutual funds with small AUM must really have to monitor their own in house accounts as well as outside trading platform that trade the funds.
For those not familiar with FinViz:
finviz.com/futures.ashx
fidelity used to sell their sector funds based on an hourly nav, I don't know if they stopped the feature due to timing or the hassle of it all.
and Charles is right any books that Michael Lewis has written has been a great read.
Regards,
Ted
http://www.bloombergview.com/articles/2014-03-31/speed-trading-in-a-rigged-market
I have a provided a link to the definition of what a market maker truly is.
http://en.wikipedia.org/wiki/Market_maker
To me, the high frequency crowd is much like a ticket scalper for a sporting event as they scalp profits from selling the ticket above its fair value as sold by the event. In many states there are laws against scalping. Something to think on.
Old_Skeet
If you read my post above, you will note that it is price discovery that is the key. Market makers did that earlier but their business model fell apart with small spreads. Staying in the market at all times is a separate issue for abnormal conditions and addressed further down.
HFT traders with access to bid data serve that particular purpose of price discovery by arbitraging spreads. Somebody has to do this and people in the media doing pop journalism aren't thinking of how this works wirhout HFT in their rants against HFT with very little understanding of how the markets work. It is a good litmus test for financial market literacy in the media.
Providing a stay in the market at all times function provided by Market Makers entails risk for them. They have to be compensated for it. The earlier bigger spreads justified it. You cannot force somebody to do it unless you either guarantee against loss or pay them enough to take that risk. Who is going to do it? Any way you do that, the cost will be borne by the investor transactions eventually.
However, that function can be eliminated if you can manage panic situations rather than designating somebody to take a loss in those situations. This is still work in progress as the few flash crashes prove it but eventually with enough circuit breakers and trading rules, you can make that function unnecessary minimizing panic induced disorderly selling. That is the better solution, so that the cost of a designated loss bearer service doesn't get folded into every transaction even in normal times
But all this misunderstood pop demagoguery is hiding the real problems inherent in this HFT based system. That we have a systemic risk created with increasing volume of HFT trading in that as pointed out liquidity can dry up instantly. This is not something you can prevent except by paying someone to guarantee it at all times but what you don't want is the system collapsing in such situations.
Currently, the system will come to a halt with no alternative price discovery if the HFT traders go away. So we have a "too big to fail system" of HFTs to get that price discovery. Just like the banks providing critical credit to economy, this gives leverage to the HFT traders to abuse the system. Rules to regulate the behavior runs the risk of driving them away from a critical function we need. This is the problem SEC has got until they can regulate the exchanges to remove this systemic risk. So, they are not in a position to do much, this pop book not withstanding.
The spread arbitrage which is what creates the price discovery isn't the "abuse". You don't need ticket scalpers for game tickets to determine a price. So the analogy doesnt hold.This arbitrage is what kept Market Makers in business earlier so this is nothing new and not specific to HFT.
The actual abuse comes from HFT not in arbitraging spread but in potentially creating FALSE price discovery based on the access to bid data. Even when there is a balanced market in bids with a tiny lower bid to buy than to sell until someone decides to move where there is no need to arbitrage, HFT traders can move the markets in a manipulative way with phantom bids, phantom trades, buying up sell inventory when they detect trending buy interest to drive the prices up. All this is legal for regular traders without using insider information.
But when HFT traders do this because of the access to bid data not available to other traders then you are allowing them to trade with the equivalent of " inside information". This is the type of trading that fits Ritholtz' phrase of "trading with no redeeming social value" though he doesn't seem to understand the nuances to differentiate this from bid arbitrage which does have a redeeming value of price discovery.
These are the kinds of things that need to be brought to light and regulated and hopefully this book will rise the awareness to pressure the SEC to come up with a mutual solution with HFT traders to prevent abuse that won't kill price discovery and bring the markets to a halt.
Even if the book is being used as a sawed off shotgun to fire indiscriminately at HFT trading without understanding how that might throw the baby with the bath water in this pop outrage.
http://www.bloombergview.com/articles/2014-03-31/michael-lewis-doesn-t-like-high-frequency-traders
from michael lewis's fellow bloomberg opinion writer ( and former investment banker and a trained lawyer). i've read them both on numerous occasions, and if i had to choose by intellect, matt levine would get my vote. michael lewis is of course great at selling books.
If they had their way, they would have shut down HFT with their lobbying but there wasn't a way to do this and so they are forced to subscribe to HFT platforms. They still don't like it, not because HFT is apparently screwing the small investor but rather they are losing their arbitrage opportunities in the old fashioned way. They are definitely NOT lobbying SEC to keep HFT.
Ironically, SEC itself is paying for a HFT platform to monitor trading patterns for enforcement which might be another gripe the big boys may have against HFT as it exposes their techniques.
The lobbying of the HFT industry is very nascent and small in comparison.
Good coverage of this issue on CNBC today. Don't have the link for it but try to find the segment with Manoj Narang, a good example of the battle between the old and new, the traders and the nerds.
The segment with Michael Lewis was interesting as well. Michael is "talking his book", literally
The whole thing is an example of what happens when big money opportunities get threatened on either side.
I watched 60 minutes. Lewis strikes me as foremost a self promoter. I thought the segment on Elon Musk was much more enlightening.
How I see it: The U.S. has been pretty proactive in weeding out the slime. They don't always catch it in time, but at least there's a better effort in the states than most nations. What nations around the world do a better job? If you own an emerging market bond or stock fund, you're probably invested in Egypt, Russia, and Mexico. I'll hold the U.S. up against nations like that any time.
Perhaps Lewis should be commended under the theory that "sunlight is the best disinfectant." To that extent, he's performing a service. Still, something doesn't seem quite right the way he's out flogging his book on all the networks. And, am I going to call T Rowe Price and Dodge and Cox today and have them sell all my holdings cause the market's rigged? Are you kidding?
Liked the response from Lewis to the vacant Sue Herera's question of whether or not this will result in further declines in investor trust: "Are you really under the illusion that the individual investor trusts Wall Street... the financial crisis wiped out any residue of trust for Wall Street even if they ever had it."
http://blogs.reuters.com/felix-salmon/2014/03/31/michael-lewiss-flawed-new-book/
@BobC, it is puzzling if you accept a premise that HFT is bad and so since SEC has not done something about it, there must be lobbying noney behind it. After all who looks after the small investor, but in any case since a lot of things have been done recently to protect the small guy, it is puzzling to see nothing done in this case. It is a self-created puzzle.
A moment's reflection will show that this logic is entirely based on the premise itself. The puzzling aspect disappears if the premise is wrong or too generalized to be actionable. Just ban HFT has as much hysteria as just ban GMO without understanding all the applications many of which is no different from what people did for decades except it wasn't done as an industrial solution.
For example, what exactly about HFT is wrong? This is what SEC needs to decide. Is it the fast execution speed some people have? The speed differential has always been there that was exploited by major traders before and the big spreads hurt the small guy much more in that case. HFT just happens to be in millisecond differentials. So there is no reason to ban it for that reason.
SEC doesn't ban things because some people think there is no need for it in their world even if they cannot pinpoint why they are uncomfortable with it and just buy into a narrative. If that was the case, we wouldn't have mobile phones.
One can go through a list in similar fashion. Is it the ability to buy at a cheaper exchange to fill an order at another exchange. This kind of arbitrage happens all the time just in much slower time for example in currency or commodities trading and actually helps reduce the spread between various locations say for example in physical Gold or Oil. The people who have the infrastructure to take physical delivery in two different locations are in a position to exploit that over people that can only take delivery in one location. The advantage comes from investing in that infrastructure. It is a valid basis for trading.
Is it the preferential access to data? There has been such preferential access based on ability to pay all the time. Do small investors get the same access to data that institutional investors do? No. Do the institutional investors get the same timely access to data that a client of GS or JPM does if they don't pay for it? No.
When SEC looks at things at this level just as FDA does regarding GMO, they might come to the same conclusion. That there is no reason to just ban it. But it is reasonable for them to look at some aspects of it to see if it is harmful.
This is not to say there aren't potential problems with it especially if it can be abused to break EXISTING laws, just as GMO can be abused. But the demogoguing reasons used against them are easier to bite into for an average person than the actual details. But SEC (and FDA) cannot do that. And that creates theories of conspiracy, corruption, etc. It is natural.
I am glad to see people like the one in the article linked by @davidmoran above start to question the popular demagoguery and provide a critique of that book. Even the Bible has its critics pointing out flaws! I see the reaction from David to such articles to be the same as the reactions from people to articles that try to look at good and bad of GMO than join the mob crying for a blanket ban.
I like Michael Lewis but in this one he appears to have over-reached for popular appeal. Perhaps, he always did that and I didn't notice it before because it confirmed my biases on those topics.
In any case, this debate is very useful.
When it comes to the GMO debate I like to remind people how much starvation existed in the world due to a host of problems associated with growing food. To better understand the science (the facts) and engineering (the problem solving) that brought about GMOs I would suggest reader familiarize themselves the "The Man Who Fed the World", Norm Borlaug.
online.wsj.com/news/articles/SB10001424052970203917304574410701828211352
Not withstanding Ecclesiastes 9:11, in some instances the race often does go to the swiftest. Timely decision making and committed execution are primary assets in the investment universe.
Over the last week nothing much has changed in that investment world except that Michael Lewis’ book “Flash Boys” is now receiving wide publicity. The book is new; High Frequency Trading (HFT) is not. We have just been made more aware of its pervasiveness.
Being early into the marketplace is surely not a novel concept. The Rothschilds used carrier pigeons to secure a time advantage in the 17th century. Jesse Livermore practiced it all the time, and after he gained renown as a heavyweight stock plunger, he needed methods and ploys to disguise his intentions. Copycats have always existed. Today, the mutual fund houses (like Fidelity) deploy more sophisticate tactics to the same end.
The issue of HFT was ushered into the investing community with the development and introduction of computers into the financial marketplace in the 1970s. Decision making and execution speed have always been a powerful weapon in the professional investor’s weapon arsenal.
Algorithmic trading and HFT have been part of the investing environment since the 1980s. Like it or not, a tested and verified algorithm doesn’t take long to evaluate a dynamic evolving situation, and doesn’t make errors in execution. So it consistently generates superior outcomes than when a human being is in the loop. HFT became common in the late 1990s, and dominated the trading volume by the mid-2000s. In 2009, it is reported that HFT constituted roughly 70% of the daily trading volume.
I’m sure you guys remember the stories a few years ago that touted these HFT houses who located a few miles closer to the North New Jersey market computer facilities to benefit from a reduced hard-wire access physical distance. Now that’s really working hard to establish a microsecond trading advantage.
Recall the 1987 stock market crash. The most likely causes for that dire event were the popular use of the Black-Scholes Option Pricing model and the overused Portfolio Insurance concept. The primary causes for this fiasco are still debated however. Another example is that, after much detailed study, the May, 2010 Flash Crash was finally attributed to the HFT cadre. Recovery was all within a one day timeframe in that instance.
So far, recoveries seem to have been rapid, and the impact of HFT on a private investor’s end wealth seems limited; my zeal for the equity marketplace is not quenched by this disclosure.
One indisputable benefit from all this computer technology is that trading costs have been substantially lowered. I remember the excessive costs I begrudgingly accepted in the mid-1950s when I bought my first stock. Wow, the price to play was huge.
Are these HFT outfits gaming the system? Yes, but historically there have been financial adventurers who have always played in that dark arena. The SEC rules committee diligently tries to minimize their impact, but clever stock operators find and exploit loopholes. However, from a personal perspective, I suspect the money drains from these operations have little impact for my buy-and-hold style of mutual fund market participation.
So, I don’t get too exercised over Lewis’ new book. The book reviews suggest that the presentation is very asymmetrical; it is not a balanced research project. It has an agenda. At some point I will read it, but I feel that I need not rush.
Based on an aroused public, I’m sure one outcome from its release will be that various government agencies will expedite investigative efforts which have been under way for several years now. That’s goodness. Some rules loopholes will be closed, but just as night follows day, new loopholes will be discovered. As a group, investment professionals are forever searching for an exploitable edge, and they find it.
None of this dampens my enthusiasm for the US marketplace. It remains basically a fair game for small time investors. It is one of the few investment opportunities that offer a high likelihood of outdistancing the erosive effects of inflation. I’m more or less sanguine over the Lewis revelation.
I want to congratulate all the MFO contributors to this excellent exchange. Your diverse and carefully documented positions on this matter really added needed depth to the continuing HFT discussion. Thank you all.
Best Regards.