In promotional interviews for his latest book, Flash Boys, Michael Lewis has said that equity markets are rigged in favour of high-frequency traders who use speed to cheat big institutional investors.
Asia has largely avoided the problems associated with these high-speed strategies because most markets have just one exchange.
A study in 2011 suggested that HFTs contributed 70% of trading volume in the US, compared to just 10% in Asia (mostly in India, Japan and Australia), but it is a growing phenomenon that regulators in the region are playing attention to.
Lewis’s book is certain to gain a wide audience. His contention is that HFTs get early access to information about prices by paying to locate their servers closer to the stock exchange than anyone else — a vantage point that allows them to see big orders and beat them to the punch by milliseconds. The investor sees one price, but gets his order filled at a higher price, while the flash trader scoops up the difference. Repeated millions of times, this is a no-lose strategy.
Lewis describes it as “skimming”, but defenders of such practices argue that flash traders benefit markets while others suggest that flash trading is yesterday’s story and profits are already much harder to come by as competition squeezes the spreads available.
This is certainly not new. Traders have always exploited technology to gain a jump on the competition, whether it was telescopes for spotting the next shipment to arrive at port or teleprinters to get the news first. Now they are using computers that can identify trends and execute orders millions of times faster than a human trader.
Does that mean that flash boys are bad guys? Lewis’s position is clear, but not all investors are so sure. Norway’s state pension fund, which is one of the world’s biggest equity investors, published a 30-page report into high-frequency trading late last year that concluded: “The jury is still out.”
The Norwegians recognise that flash traders are not all created equal. Some firms arbitrage price differences across multiple trading venues, while others earn bid-ask spreads and rebates by providing liquidity. “These strategies keep prices efficient by correcting mispricing across instruments,” they wrote.
It is the predatory strategies that do the skimming. Some of these traders exploit inefficiencies in market structure or pick off predictable algorithms used by less sophisticated investors. Others use ultra-fast connections and high bandwidth to identify (or create) stale prices and get in front of other investors.
These predatory strategies do not add liquidity — they actively compete with other investors for it — but nobody really knows which strategies are most common or what the long-term effects are on transaction costs, price efficiency, volatility or anything else. This is largely because investors have not traditionally analysed such things with much precision, meaning that we don’t have a strong historical benchmark.
A 2013 review by Australia’s securities regulator found no evidence of systematic manipulation or other predatory behaviours from HFTs, though it noted some basis for the perception that they created “excessive noise” in the market.
More study is warranted. According to a survey of market participants by Tabb Group, a capital markets research and strategic advisory firm, Lewis’s book will almost certainly encourage further investigations by New York’s attorney general and increase the likelihood of regulatory change from the SEC.
Greater transparency would help restore confidence and win back public trust. “Giving a wider audience a glimpse into the modern financial framework can help clear up the idea that everyone on Wall Street is a villain,” said Tabb in a report based on its poll. “After all, sunlight is the best disinfectant.”
The complaint from institutions, as told by Lewis, seems to be: “I have a hunch that my performance is worse, for reasons I don’t understand. Please can you fix the market so that my trusty old strategy is once again successful?”
A better approach might be to adapt to the new reality. Indeed, the hero in Lewis’s book, Brad Katsuyama, did just that. He left his job at Royal Bank of Canada to set up IEX, an exchange for institutional investors that uses a 100-kilometre spool of fibre to slow down the predators and create a level playing field.
The problem is that most investors either don’t know or don’t care that they might be losing pennies in transaction costs. If there is an effect, it is not that obvious.
There could even be an upside. A report on equity trading by consultants Oliver Wyman advises investors to assess and adapt because the new environment presents profit opportunities for early movers.
Markets have never existed in a perfect balance between long-term investors and predatory speculators, and many of the same arguments were raised in response to computerised trading and the use of algos. In both cases, the result was the same: lower costs, greater liquidity and more efficiency.
Flash trading requires investors to think about market structures in ways they have not had to before, but so what? Nobody is owed a return from the market.