A bit of my weekend reading was this nice short piece by Donald MacKenzie in the London Review of Books: Be grateful for drizzle.
MacKenzie takes a level-headed and clear-eyed look at the phenomenon of High Frequency Trading as it stands in the summer of 2014.
One interesting topic that he covers involves the difference between programs which play the role of market-makers, and programs which play the role of traders.
Market-makers are beasts of burden in the market: their job is to match up interested buyers with interested sellers, charging a price for this service made up of the spread between the purchase price and the sale price and the rebate awarded them by the host exchange:
If a market-making program is trading Apple shares, for example, it will continually post competitively priced bids to buy Apple shares and offers to sell them at a marginally higher price. The goal of market-making is to earn ‘the spread’, in other words the difference between those two prices – in Apple’s case, a few cents; in many other cases, a single cent – together with the small payments (around 0.3 cents per share traded) known as ‘rebates’ that exchanges make to those who post orders that other traders execute against.
Adam Smith's "invisible hand" works well here: if the market-maker's spread is too large, others will offer a lower spread and will take business away from the weaker program; this competition drives the market-making programs to be efficient and to offer the smallest possible spread, which benefits all participants in the market.
Traders, on the other hand, are opportunists, attempting either to buy low and sell high, or to sell high and buy low; in either case, the trading program attempts to identify the direction that a stock price is moving and front-run it. These traders don't really care whether the stock prices is moving up or down; they just care whether they can reliably detect that movement before any other trader can, thus being able to profit from it:
you have to pay the exchange a fee, rather than earning a rebate, and, if prices don’t move, your program can end up simply ‘paying the spread’ to market-making programs, because it will have to sell more cheaply than it buys. However, if an HFT program can identify a trading opportunity larger than the ‘spread’ (a high probability that, for example, the price of the shares being traded is going to rise or fall by several cents), then it may well need to act immediately and aggressively, before other programs do.
Trading programs don't benefit any market participants other than themselves, which is why they've earned considerable ire.
However, it's not clear that they are intrinsically evil; they are just feeding off of inefficiencies elsewhere in the system. MacKenzie discusses, in detail, one such inefficiency, told in Michael Lewes's Flash Boys, involving the way in which a large bank decides to execute an extremely large order for one of its pension fund customers; the bank's poor handling of the order results in a tidy opportunity for these aggressive trading programs.
And as MacKenzie notes, behind all these high-tech maneuvers are the hard-earned savings of ordinary people like you and me:
Behind orders from banks’ institutional investor customers are people’s savings and pension funds. Flash Boys has been widely read as a morality play, a story of evil-doing high-frequency traders. But it can just as easily be read as an account of banks that either wouldn’t, or didn’t know how to, take best care of their own or their customers’ orders. To their credit, the Royal Bank of Canada team took action once they saw the disadvantage they were labouring under. I am assured by a source that other banks have done things to reduce the problem, for example moving their smart order routers from Manhattan into the data centres in New Jersey. All things considered, I suspect that what drains most money from pension funds and other savings are the high fees charged by those who manage them, and the excessive trading they often engage in, not high-frequency trading or even the incompetent handling of orders.
Over the years, as I've learned, in bits and pieces and dribs and drabs, about the activity of High Frequency Trading, I've come to roughly the same conclusion as MacKenzie appears to have arrived at:
- Automated market-making is not only not evil, it's actually been quite beneficial. Spreads have dropped, liquidity is generally quite high, individual investors like myself have access to very open and fair markets, and computers are actually very good, and very very efficient, at doing the automated market-making and book-keeping necessary for all this to occur.
- Aggressive traders, who think they can predict market movements, or at least detect and respond to them faster than others do, can be quite annoying, but there's really no evidence that they are a problem worth wasting much energy over.
- Poor oversight, transparency, and regulation of retirement funds, on the other hand, is the source of much waste if not outright corruption.
When a bank's inefficient trading desk causes a large order submitted by a state government's public employee retirement fund to be mis-handled, resulting in a bad execution, no money is strictly speaking 'lost'; however, a certain amount of money is effectively transferred from the retirement fund to those trading programs which took advantage of that poor execution.
And that means that those trading firms took money from you and I, since in the end that public employee retirement fund is funded by the taxes that we pay that are used to pay the salaries of those policemen and firefighters and teachers and contribute to their retirement savings.
My personal bug-a-boo in this area involves 401K fund selection. Individual employees like myself are at the mercy of what is provided by my company's retirement plan, which in turn is at the mercy of what the "financial services" industry is willing to provide. And, naturally, most of that industry wants to provide high-fee, poorly-run funds which take my hard-earned savings and send a depressingly large amount of it to the plan servicing company's executives.
But as MacKenzie points out, it's important to keep your eye on the overall picture here:
The right question to ask about high-frequency trading is not just whether high-frequency traders are good or bad, or whether they add liquidity to the markets or increase volatility in them, but whether the entire financial system of which they are part is doing what we want it to do. Of course, we want it to do several things, but I’d say that high on the list should be putting people’s savings to the socially most productive uses, while preventing too much of those savings being wasted along the way.
Speaking a couple of years ago to Bloomberg Businessweek about the new, faster cables, such as those planned by Hibernia, Manoj Narang, founder of the HFT firm Tradeworx, commented: ‘Nobody’s making extra money because of them: they’re a net expense … All they’ve done is impose a gigantic tax on the industry and catalyse a new arms race.’ The chief economic characteristic of an arms race is that all the participants have to spend more money, and none of them ends up any better off because of it.
The world financial system is capable of great wonders, but also capable of great devastation (witness 2008, after all).
Somewhere in there is the possibility of a system whose power is harnessed, but whose threat is contained.
And the road to that hopeful future lies in the work of clear-thinking writers like MacKenzie, who take the time to study the details and understand them and explain them to people like me so we can think about them.
So if this is a topic that interests you, I recommend you read MacKenzie's article in full.