Michael Lewis: Is The U.S. Stock Market Rigged ? 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.
A Better Retirement Planner Reply to
@Old_Joe:
Hi OJ,
Thank you.
We share many similar traits and experiences. I really do believe that we are on the same page far more often than either you or I realize.
Historically, there has always been risk in carting stuff from one place to somewhere else. Each situation is different and usually requires an engineering tradeoff study.
Generally, trucking, the rails, and pipelines are candidate approaches, each offering special advantages and varying risk levels. I suspect most engineering assessments would conclude that pipelines usually provide safer transport prospects given continuously improving technology. We’ve made
quantum leaps since the successful Roman aqueduct system carried water over hundreds of daunting mountain miles.
Best Wishes.
AQR Risk Parity I AQRIX Reply to
@scott: Thanks scott, as always. I just downloaded "The Quants" on Audible. Here is summary for others:
Publisher's Summary
In March 2006, the world's richest men sipped champagne in an opulent New York hotel. They were preparing to compete in a poker tournament with million-dollar stakes. At the card table that night was Peter Muller, who managed a fabulously successful hedge fund called PDT. With him was Ken Griffin, who was the tough-as-nails head of Citadel Investment Group. There, too, were Cliff Asness, the sharp-tongued, mercurial founder of the hedge fund AQR Capital Management, and Boaz Weinstein, chess "life master" and king of the credit-default swap.
Muller, Griffin, Asness, and Weinstein were among the best and brightest of a new breed, the quants. Over the past 20 years, this species of math whiz had usurped the testosterone-fueled, kill-or-be-killed risk takers who'd long been the alpha males of the world's largest casino. The quants believed that a cocktail of differential calculus, quantum physics, and advanced geometry held the key to reaping riches from the financial markets. And they helped create a digitized money-trading machine that could shift billions around the globe with the click of a mouse. Few realized that night, though, that in creating this extraordinary system, men like Muller, Griffin, Asness, and Weinstein had sown the seeds for history's greatest financial disaster.
©2010 Scott Patterson, Random House
