Just like reality TV. But there’s reason for optimism regardless.
High frequency trading (HFT) is where traders use a combination of hardware and software to see how much someone else is willing to buy or sell a given security for, fractions of a second before the competition does. It’s a bit like being able to bet on a horse race from the future—you already know who’s crossed the finish line first.
Yes it’s dodgy: using computer algorithms traders are technically able to trade in ways that would be illegal if they committed the trade manually. Despite proponents’ claims that it aids in price discovery and market liquidity, HFT has the ultimate effect of skimming profits from the rest of the market. And yes, the rest of the market in all likelihood does include you, even if you’re not an investor, because it includes the pension funds and mutual funds that 401(k)s invest in. The practice has been going on for something like a decade, but because of slow-moving, under-resourced regulators, it’s managed to largely fly under the radar.
That’s changed this year. One reason for the flurry of attention is author Michael Lewis – a Vanity Fair contributing editor famous for his books MoneyBall, The Blind Side (which became Hollywood movies), Liar’s Poker, and The Big Short – has just released a new book, Flash Boys, about HFT. Given his high profile and critical acclaim (the New York Times said “[n]o one writes with more narrative panache about money and finance”), Lewis’s book is refocusing a lot of critical attention on an industry the public didn’t exactly have high regard for to start with.
High frequency traders have also come to the attention of New York Attorney General Eric Schneiderman, who sent subpoenas to more than a half dozen high frequency trading firms within the last two weeks according to the Wall Street Journal:
The attorney general is seeking details about whether the trading firms have secret arrangements with stock exchanges or other trading venues, such as dark pools, that give them the ability to trade ahead of other investors.
Some of the things Schneiderman appears to be focusing on are probably not worth the effort. The practice of colocation for instance, where trading entities place their data centers inside stock exchanges is a hard thing to address and change. Other things like data feeds however, and receiving data before others, are probably not nearly as hard.
The U.S. Securities and Exchange Commission (SEC) also appears to moving towards some kind of a crackdown on HFT, even as the FBI has also opened an investigation into the practice.
Image: Tomas Fano
Bringing a knife to a gunfight?
Given what we know of the culture on Wall St, it’s a given there are bad actors involved in high frequency trading, so it’s disappointing the SEC has made little effort to find them until recent media attention directed its focus. It’s arguable whether the FBI investigators have the resources to do a better job than the SEC, which means it’s hard to know whether the FBI investigation is just for show. Given how specialized this sector of the industry is, it will depend on what kind of hiring or staffing they’ve done. But then again, there are certainly whistle-blowers out there, who are hopefully helping to drive any investigation. And the threat of jail time can be a wonderful motivator for people with highly specialized knowledge who would otherwise be reluctant to share it.
One exchange where HFT is not welcome
One of the stars of Lewis’s book is a Canadian trader called Brad Katsuyama, formerly Global Head of Electronic Sales and Trading at RBC Capital Markets, and arguably the first whistleblower to discover what was going on with HFT. Fed up with what he discovered about the way markets were being gamed, Katsuyama ultimately left RBC to set up a new, more transparent trading exchange called IEX, which allows all traders to compete on a more even footing. A former high frequency trader with a conscience named Dave Lauer was a consultant for the nascent exchange, helping to design the technology systems there.
Lauer had previously worked as a hardware engineer building low-latency equipment for high frequency trading, as a quantitative research analyst for high-frequency traders, and as a contract worker in Goldman Sachs’ tech group. He’s written high-frequency trading algorithms and done mathematical modeling, and arguably knows more than anyone else on the planet about high frequency trading.
The main difference with IEX is really “a focus on transparency,” says Lauer. “You can go to the website and you can see how many shares are trading every day. There’s no other dark pool that does that. And then they give a lot of other statistics in terms of what the makeup is of the order sizes, the fill sizes, on the pool. In March they averaged almost 19 million shares a day, and in April they’ve been between 25 and 30 million a day, so they’re growing really quickly.”
It’s unsurprising there has been pent up demand for an exchange like IEX, but what was surprising was how much the buy side has been a huge supporter: “even Goldman came out and supported IEX,” Lauer reveals. “That was surprising.”
(Matt Taibbi might note however, that the great vampire squid is well known for relentlessly jamming its blood funnel into anything that smells like money.)
What should a healthy market look like anyway?
With partner Chris Nagy, Lauer has launched a new company called Kor which focuses on market structure and lobbying Washington on behalf of all the market participants who aren’t big high frequency traders. As part of this push they’ve launched the Healthy Markets Initiative where they’re trying to push a platform of changes that Lauer says the SEC, along with a pretty broad cross section of the industry, are open to. “There are a lot of technology reforms in there around market data feeds and latency that we’re also pushing,” says Lauer.
For instance, KOR is pushing for the SEC to open up access to data to provide a better understanding of markets, and encourage objective and quantitative research on markets. KOR wants to open up access to MIDAS or Market Information Data Analytics System, and to enhance MIDAS with hidden orders, dark pool orders, and IOCs. “The MIDAS data center is very incomplete,” argues Lauer, “and it’s closed off to everyone, so from an open data and open source perspective, that’s not the way to go.”
Lobbying against the lobbyists
But given that a majority of SEC staff earn a pittance compared to the people they are meant to be regulating—until they inevitably leave and end up working for Wall St—is it really possible to have good regulation of markets?
“Ah… no!” laughs Lauer.
Instead, Lauer and Nagy want to fight fire with fire. They aim to take on the lobbyists of “bulge bracket” firms – companies which are primary dealers in U.S. treasury securities, and which comprise the world’s largest and most profitable multinational investment banks whose clients are large corporations, institutions, and governments. When it comes to market regulation these sorts of firms are currently the only people who have a real voice in D.C.; a major problem as Lauer sees it.
“And so that’s why with Healthy Markets we’re looking to work with exchanges, high frequency firms, buy-side firms, and a few brokers, smaller brokers. All of those firms, they feel drowned out. If we bring them all together, then at least we have a voice that’s as large as the other side.”
Who ate all the pie?
It’s interesting that in the face of all other American industries that have undergone a digital transformation towards greater automation, finance seems to stand alone as having grown its share of the economy. This could mean that Wall St’s share of the economy is overdue for downsizing, given how much of it is now algorithmically driven.
“I think that when you look at GDP and you see that from 1929 to 1988, Wall St and financial services averaged 1.2% and peaked at 1.7%, versus after 1988 where it peaked at 3.3% in 2005,” says Lauer. “To me that’s a dramatic problem, and I think that you would expect the benefits of automation and technology to reduce that or at least maintain in line with historical norms, so I think that’s a big flashing red light.”
Ain’t going nowhere, baby
This does not mean however, that the days of high frequency trading are numbered. On the contrary, “I don’t think it’s going anywhere, ever,” argues Lauer. “I think it’s the new… this is what markets are now. I think that profitability will probably continue to drop, but again it’s questionable how much it’s dropped so far. It’s a very secretive and closed system. But I think that even despite reforms, and the reforms that we’re pushing would change some of the aspects of high frequency trading and change what is profitability in the market, but we have the support of high frequency firms, because a lot of them want to see a more transparent market, they want to see democratization of order flow instead of payment for order flow, and competition over order flow. So I don’t see it going anywhere. I think it will be more highly regulated, that’s inevitable, and that’s been inevitable for a while. What that means is hard to say.”