I've been dying to write about this book for some time. Not to enlighten any readers, but to decide if I actually understand the allegations again HFT. So, with the post, I throw aside all rules of the blog. If I'm clearly missing the point, I will not be offended if you let me know it. But please back up why I am wrong. I personally think this a great topic for debate.
Need-to-knows about our market
Now, I have no relation to Wall Street/HFT/Institutional Investing. Apart from a half hour visit to the trading floor, of which I gleaned the bell and floor have little relevance to the market (not only that but the trading floor is more aptly named the "casting set" for stock news programs). I haven't the faintest a posteriori knowledge about what happens in the market. That being said, here is what I think you need to know:
High-Frequency Trading as I know it
- I am going to use AFAP to mean "as fast as possible"
- There are several exchanges for trading, each with its own incentives, and purchasing options
- There is a speed-race involving HFT's and Banks needing quicker access to the pricing.
- Exchanges do allow investors access to these low-latency price streams
- These streams provide quicker updates than public streams
- Exchanges can offer small price incentives (kickbacks) for purchase/sale of certain stocks at certain prices
- Dark pools are bank markets intended to reduce market impact.
- They do not provide information on their trades
- Banks host their servers in the basement of exchanges to get AFAP market information
- There is a direct pipe built from Chicago to New Jersey to gain AFAP market information, and most Wall Street banks pay millions for this access
It's likely a foolish task to summarize and respond to the Flash Boys book in a blog post, but I never claimed I'm not foolish.
High-Frequency Trading is the software that fuels the market as we know it. When I want to play investor and sell my like 4 shares of GE stock, I no longer call a broker and have him sell my shares. Instead, I use a magical online broker like Scottrade, eTrade... etc to make my transaction. I think this is where most of the confusion around High Frequency trading exists (for normies like me).
If we think about the stock market (all markets really); we know that a seller can only sell if there is a buyer to buy. This was the role of the stock broker was to position these two together for each transaction, and this was the role for nearly a century. Of course, the computer and internet became the paradigm for information exchange, and a logical choice to expand the market. The important part of this, is that although the markets could be managed and used online, the rules of the game did not change. A buyer and seller still need to be matched, and logically someone still had to do this. This was simply no longer a person, but a computer program. Now, this is pretty great for everyone (except the broker). Computers are much more efficient at finding buyers and ensuring best available prices, and investors could get real-time access to their investments. But fundamentally, this was still the same game.
HFT systems, as intermediaries, are market makers.
They buy and sell in a market like anybody else, just quicker. In fact, they increase trading in the market because they are always looking to buy and sell, really quickly.
In this new scenario, it became much more difficult for an individual to see where a trade was executed, and especially what was happening behind the scenes. Brad, in Flash Boys, identifies himself as someone who became obsessively curious with this subject. As a banker at RBC in Canada, he found that his own execution of trades would artificially raise/lower the price on his own transactions. He identified that the act of making his bulk purchase would raise the market price of the stock he was buy, and would essentially cost him significantly more. It does not make immediate sense why your own market request could change the market price. His findings are that the market has become so fast, and so intertwined that we have lost sight of exactly what is happening. He essentially spends a few years finding the expertise to unravel the mechanics behind the execution of a trade. He identifies high-frequency trading as the culprit and and a few factors that make it a rigged game.
Dark Pools are Opaque
Dark pools are essential to understanding HFT. These are set up by institutions as private markets to execute trades. Michael Lewis describes them as a blackbox. A trade order is sent in, something happens, and then a transaction price comes out. In 2007, Brad sees the activity in these dark pools going off the charts, and all the big banks are sending more and more trades to be executed in their dark pools. A fundamental part of these dark pools is that they produce little to no information. When a trade enters a dark pool, the trader can no longer see what exchange the trade was made on what happens to his order, until it is completed.
Computers are Fast
The execution of a trade is incredibly fast, the click of a button on a computer. So is it particularly difficult for a human to understand all the events that take place immediately when the button is placed. What Brad finds is that HFT market-making techniques also included, placing buy and sell bids all over exchanges, and aggregate exchange information pricing AFAP. So when Brad places a bid to buy 5,000 shares of GE at a market rate, if the HFT has a sell-bid on the exchange, they will receive immediate notification of the interest to buy. They will quickly make their own purchase of these shares, increasing the market price, and turn around to fulfill Brad's order at the higher market price. This market-making arbitrage is how Brad's own trade could artificially inflate his own purchase price.
Exchanges are funky
Now, this is not the whole story of course. The market is considerably more complicated, orders come witha bid-ask spread, orders can have limits, and exchanges can complete numerous types of trades. Brad identifies exchanges that have incentives for market-makers, specifically incentives to buy, or sell. As in buyers of stocks can get a few cents back (rebate
) for specific purchases to incentivize the purchase of certain stocks or commodities. He sees these as funky incentives that most traders ignore, but are ripe for HTF. Back to Brad's purchase of 5,000 GE shares. When a HFT systems elects to fulfill Brad's request, they can create a higher margin on their intermediary relationship, by purchasing the shares from an exchange that may have an incentive for that purchase.
HFT reports to no one
HFT systems live in dark pools, and execute trades in a blackbox. Therefore, there is no public record of their abitrage. All that is visible to the end users is that the system created a transaction. Therefore, High Frequency Trading is market-making and beneficial to the system.
So, as Brad begins to unveil the web that is our modern market. He begins to play whistleblower and tries to notify the banks of the current system that the market has become. Of course, no one seems to care. It's the system that they all currently flourish, and there isn'y much incentive for radical change. Brad, credit to him, isn't okay with this. His solution: open an exchange, IEX
, which you can see boasts itself free of this latency arbitrage, and no rebates.
Now, I've read quite a few responses to Flash Boys, and they usually revolve around Brad being very very ignorant. They downplay the secrecy of HFT, show most usage of HFT is not abusive, highlight the benefits of this market-making, and show that HFT is actually reducing the bid-ask spread in the market and drives down the volatility for investors. These points amount to the idea that Brad needs to use limits on his block orders, disguise his large block transactions, and generally be more careful with his investors' money. Just this morning on Forbes I read, Don't Blame High-Frequency Traders For The Mistakes Of Dumb Traders
My problem with this argument is that its a lot like saying, "Dont blame war profiteers for the mistakes of Dumb Leaders". I wouldn't overtly blame war profiteers, but I also wouldn't defend their business. Also, it wouldn't be a shame to see it disappear.
I feel that these people shouldn't be upset with Brad for his actions, but instead be thrilled with his new exchange. It has limited the opportunities of abusive HFT schemes, and as far as I can tell doesn't put into jeopardy the good uses. The market-makers can use IEX, just like everybody else. But as I say this, I think it is very important to note the value of HFT. If I want to sell, I want to sell immediately, and HFT makes this happen. They take risk of purchasing at a price and finding a buyer, and hedge it across an immense volume. I think this purpose deserves a cut, and I'm glad that this function is not controlled by the exchange, but I do believe the world is better off if "ignorant money-managers" of hedge funds and my 401k cannot mistakenly lose my savings.
Another reaction I have come across lately is a Tax on Investing
(note the comedy that these are both Cornell professors seemingly at odds on the value of HFT). Let me remind you of my philosophy that I've never shared before:
"Taxes really only work to limit bad behavior"
As in, cap & trade or incentivizing the reduction of pollution. Investing is not inherently bad behavior, and is generally helpful to economic growth. A tax on investing essentially just reduces the margin of the private sector and gives it to the government. It also would essentially do nothing different that commissions already seem to do (Yes, HF Traders pay commissions too). And, yes that really is my motto. Maybe soon I'll write my post on Bill Gates' theory of the destructive nature of the income tax.