Yesterday we reported on Michael Lewis' claim during CBS' "60 Minutes" this past Sunday that the U.S. stock market was "rigged."
Lewis' assertion reflects the findings from his new book, "Flash Boys: A Wall Street Revolt," which frames a picture of financial markets as being largely controlled by big banks whose high frequency trading (HFT) operations enable them to capture trading profits at the expense of the average retail trader.
In Lewis' view, your average trader cannot compete with computerized trading systems that receive and trade on new market data in mere milliseconds, capturing small profits on each trade which grow into large ones over billions of transactions.
Traders at Getco, a private company with fewer than 250 employees, use powerful computers and algorithms to engage in high-frequency trading. Here, a Getco trader at his workstation. (Image Source: Carlos Javier Ortiz/The Wall Street Journal)
As the New York Post summarized it:
"The robots’ high-speed networks allow them to buy the stocks milliseconds in advance — enough time to push up the price for the investor that had made the original order.
“They’re able to identify your desire to, to buy shares in Microsoft and buy them in front of you and sell them back to you at a higher price,” Lewis said. “The speed advantage that the faster traders have is milliseconds … fractions of milliseconds.”
The villains are a “combination of these stock exchanges, the big Wall Street banks and high-frequency traders” who are bagging billions every year with the practice, Lewis said in an interview Sunday with “60 Minutes.”
The victims, Lewis adds, are “everybody who has an investment in the stock market."
The FBI has even opened an inquiry into potential abuses related to HFT.
But not everyone is buying Lewis' argument.
In Bloomberg, Matt Levine proposes an alternative narrative to that put forth by Lewis, of "a clever young outsider applying rigorous quantitative thinking to revolutionize a stodgy stupid business that is bad for its customers" [the protagonists of his book who create an alternative to "rigged" markets] versus "the stodgy stupid one" [big banks and other institutions that rely on high frequency trading operations].
In Levine's alternative world, those engineers who created the high frequency trading programs might actually be the true revolutionaries, defending against or even chipping away at the advantage of those with inside institutional knowledge at the big banks.
As Levine argues, HFT trading systems can actually be seen as having been developed to undercut the big banks, who previously could trade on superior information and generate superior profits due to their size, scale, speed, relationships and computing systems. HFTs in Levine's reading may be the real disruptors of the "stodgy" trading industry.
Levine writes, contra Lewis:
"along come some smart young whippersnappers who replace gut instinct with statistical analysis. Instead of relying on some equity trader's ample gut to guess what orders are likely to move the market, you can use a computer to figure it out, and then automate how you trade. If you build your computer right, you won't be blindsided by informed orders that go against you, like a lot of mortgage-backed securities traders were.
And this means that you can quote a much tighter spread: By being smarter than the competition, you can also be leaner and more efficient. You might quote Microsoft at $39.97 bid and $39.98 offered on every exchange, knowing that as soon as someone hits your bid on one exchange, you can instantly move your market down to $39.96/$39.97 everywhere else. This reduces your risk of being picked off by trading with informed traders, which lets you make a profit even on much narrower spreads. You can charge less to trade by being more informed.
He summarizes his argument as follows:
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.
In my alternative Michael Lewis story, the smart young whippersnappers build high-frequency trading firms that undercut big banks' gut-instinct-driven market making with tighter spreads and cheaper trading costs."
Over at Forbes, Tim Worstall writes that contrary to Lewis' takeaways:
The effect on the small investor is entirely the other way around. Small investors benefit from the existence of HFT. So do large investors in fact. It could be that HFT has other risks and problems. Perhaps it makes the markets more fragile at times of stress, there’s a possibility, as with the Flash Crash that people can misprogram their algos and thus make the market horribly volatile for a short time...
But Lewis’ contention is that in the average operation of the HFT market it is somehow taking money from the small investor and handing it over to those plutocrats: and this is something that just isn’t true.
Why does Tim Worstall argue that Lewis' thesis is wrong?
Worstall's argument centers on the concepts of spread and liquidity.
The spread represents the difference between the highest price at which buyers are willing to bid for an asset, and the lowest price at which sellers are willing to sell an asset. Traders profit in part by quickly exploiting inefficiencies in the marketplace by "buying low and selling high," in the process matching willing buyers and sellers.
Liquidity in context of financial markets reflects the ability to and speed at which sellers can sell and buyers can buy a given stock or bond. If you own 100 bonds of a bankrupt company like Sbarros, which would likely be difficult to value and for which the number of buyers might be relatively small, the liquidity of your position would likely be significantly lower than if you were to own 100 shares of Wal-Mart. Generally the less liquid the asset (i.e. the smaller number of willing buyers and sellers, and/or the smaller the supply of shares or bonds outstanding), the smaller the trading volume and the wider the spread, and the more liquid the asset the higher the trading volume and the smaller the spread.
Worstall believes that HFTs improve liquidity and thus lower the spreads, meaning that the average retail investor loses less on each of their trades than they would have before HFTs came into being, thus undercutting traditional traders who had controlled wider spreads and thus captured wider profits:
"As Lewis has noted in the New York stock markets they’re [HFTs] just over 50% of all trading right now. So they’re obviously 50% of all the liquidity. Which means that they’re also 50% of what reduces the spread on those markets. And that, in turn, means that everybody buying and or selling stocks has had the tax, that spread, that they must pay reduced by their activity. And while I’ve not got the detailed numbers to prove it I’d be willing to bet a very large sum indeed that the reduction in the spread is greater than whatever amount the HFT guys might be able to make by front running a purchase order from anyone except the very largest of investors trying to move a truly monumental amount of any one stock.
So I’m afraid that Lewis has got this the wrong way around. The HFT guys are making money, yes indeed they are. But they’re making money in much smaller sums than the general investors in aggregate are saving through the collapse in spreads as a result of the extra liquidity. HFT, at least in normal market conditions, benefits the small investor most certainly, not costs her."