By Ben Brunson, Special for USDR
Michael Lewis’ new book and his recent appearance on 60 Minutes has ignited heated discussion about High Frequency Trading (“HFT”). The lasting comment from his whirlwind publicity tour is that the market is “rigged.” This is, of course, a provocative statement intended to sell books. But the question lingers: what about HFT is truth and what is hyperbole?
Let’s start by defining HFT. It is short-term trading of securities using computers that have been programmed with specific trading rules, or algorithms. How short-term? Most HFT strategies involve buying and selling equity securities within seconds – often milliseconds.
When most people think of trading on Wall Street, they envision the open outcry trading shown in the movie Trading Places or the trading desks of major firms like Goldman Sachs. Indeed, this type of human trading still exists and is still an important part of the financial system. But HFT, which removes humans from the loop, has come from nowhere to account for over half of the trading volume in U.S. and European equity markets.
How is this possible, you ask? Don’t all equity trades get done through human specialists on the floor of the New York Stock Exchange? The reality is that the days when GM’s stock price was set by the specialist at the NYSE have become an anachronism. While electronic trading has been around for 40 years (the NASDAQ was the world’s first electronic exchange), an explosion in electronic exchange volume began in the late 1990s and forex trading online. It is not coincidence that electronic trading grew rapidly as the Internet became more ubiquitous.
The growth of computing power and connectivity propelled the evolution of a type of trading that has been around for decades – quantitative analysis, or “quant” trading. When I was at Salomon Brothers during the late 80s and early 90s, we had no shortage of smart people designing trading strategies using computers and quantitative analysis. When it was time to trade, however, we executed our strategies through the traders on our trading desk. It was computers telling us what we wanted to do, it was human traders getting it done.
Modern electronic exchanges allow us to take the human trader out of the loop. Computers programmed by traders can now interact directly with exchange computers. This has created all sorts of opportunities to make a profit, and Wall Street is very good at pursuing profit opportunities.
A lot of HFT is simply taking advantage of speed to trade on public information faster than the next guy. This type of trading is as old as Wall Street. It has always been true that a trader at a large Wall Street firm could act faster than you could. In fact, the advent of the Internet and online trading has actually helped to level the playing field between the individual investor and Wall Street. The exception to that is HFT, but the critical fact to keep in mind is that HFT is capturing pennies. In exchange, HFT provides a level of liquidity and efficiency to the market that has not historically existed.
So are the markets rigged? In my opinion, they are not, even though there is a class of HFT that is arguably illegal. If I trade faster than you do based on public information, then that is simply my reward for investing in better technology or paying closer attention. But if I have information that the public does not have and I trade on that, then that is insider trading – and it is illegal. In the world of HFT, this sometimes comes from paying for access to information seconds – or even milliseconds – before the public at large. This is the type of trading that Michael Lewis was referring to when he made his inflammatory comment. Is this a huge problem in the market? No. Nonetheless, I expect regulators to address the situation and I welcome that.
But history also teaches us another lesson about trading. Success (read, profit) begets imitation. Imitation begets systemic risk. I lived this first hand on October 20, 1987, when the financial fad of the moment – portfolio insurance – kicked in simultaneously across the investment community and swamped the markets with sell orders. The result was the second major crash to hit Wall Street in the 20th Century. We got a small taste of how HFT can feed such a situation during the Flash Crash of May 2010.
In a world in which millions of trades can occur before a human being can turn off a computer, the systemic risk is one that we are as yet unable to define – but it exists and it is growing.
Ben Brunson is the author of the thrillers Esther’s Sling and The Falstaff Enigma. He is a University of Chicago trained economist, financial expert and historian who followed a long business career with a second career as a writer and commentator.