Since the publication of Michael Lewis’s book Flash Boys, there has been a surge in the discussion about high-frequency trading and high-frequency traders (“HFTs”). Individuals have for years been expressing opinions about the practice, which, at its core, is the use of high-speed computing and communications equipment to gain a trading advantage in securities markets. With that advantage, HFTs are able to make essentially riskless profits. One striking aspect of Mr. Lewis’s book is the revelation of how few people, even sophisticated market participants, actually understand the nitty-gritty of how our modern, electronic securities markets operate. Mr. Lewis’s work has helped us improve our own understanding and many of the facts we will cite herein were found in his book, but we disagree with his main conclusion as it relates to our business. While we agree that high-frequency trading does represent a potential systemic risk, the practice as such is inconsequential to our clients’ investments.
Stock Markets 101
The goal of Flash Boys is to demonstrate that the stock market is rigged in favor of a small number of HFTs and to the detriment of ordinary investors which, somewhat ironically in this case, consists of hedge funds, mutual funds, and Wall Street banks. In fact, the hero of his story is a young stock trader making $2 million a year at Royal Bank of Canada. Back in early 2007, this trader discovered to his frustration that when he attempted to execute trades at the listed market bid or offer price, those quotes disappeared from his computer screen as soon as he entered the orders. This phenomenon occurred consistently, and no one in his company could explain why. The cause, it turned out, also had market consequences, but before getting into that, we’ll first take a step back and explain how U.S. stock markets used to operate, and how they have changed in the new millennium.
A stock exchange is where traders and investors meet to buy and sell shares of ownership in publicly listed companies. Individual investors generally aren’t able to transact on an exchange themselves, so they have their investment managers or retail brokers do so for them. These “institutional investors” execute their orders through brokers who are members of an exchange. Traditionally, those brokers, in turn, worked through the designated market makers for specific stocks. These “specialists” maintained the order book (the list of requested transactions), and used their own capital to buy or sell from institutional investors throughout the course of the day. Importantly, they also had the affirmative obligation to provide liquidity and maintain orderly price movements in times of turmoil. Their compensation was the difference or “spread” between the prices at which they agreed to buy and sell. It was a lucrative business for the specialists that became more difficult in 2000, when decimalization changed the standard pricing increment from an eighth of a dollar (12.5 cents) to a penny. Spreads narrowed, leaving little cushion to hold the inventory necessary to facilitate trading. Then in 2007, Regulation National Market System (“Reg NMS”) was established by the SEC and electronic trading really took off.
The regulation’s goal was to foster competition among stock markets and thereby guarantee that trades be executed at the best possible price. It was a worthy goal, but as with much regulation, it failed, primarily because the reported national best bid and offer prices were calculated more slowly than HFTs could transact. After Reg NMS, electronic stock markets began to proliferate, such that the U.S. had 13 public exchanges by 2008, each of which had a computerized “matching engine” that did what specialists had done before. In addition, there are approximately twice that many private exchanges set up by large broker-dealers and others, known as “dark pools.” Overall market volumes doubled in short order, while HFTs grew to account for half of all trade volume and, more ominously, more than 90% of all listed quotes.
Do HFTs Serve Any Purpose?
The basic business model of an HFT is to identify an inefficiency in the trading system and exploit it for a small amount of money as often as possible. One example is electronic front running, wherein an HFT’s computer-based trading algorithm might see a large buy order hit one exchange, at which point it buys all the lowest-priced offerings at other exchanges, then sells it to the original bidder at a higher price. It can only do this because it operates faster than both the bidder’s system and the system that determines the national best price. How do the HFTs do that? By physically locating their computer servers at the stock exchanges’ data centers (for a fee) and establishing the shortest and fastest possible fiber optic links between themselves and the exchanges. At the cost of millions of dollars in state-of-the-art technology, they have established a timing edge that might be counted in microseconds, but enables them to skim a penny or even a fraction thereof from another market participant’s transaction. Since the algorithms handle everything, this can occur millions of times without further human intervention.
Those who support the high-frequency trading industry claim that HFTs provide liquidity to the stock market. Doing so is a legitimate service, for which designated market makers are compensated. The problem is that not all HFTs are designated market makers, and so don’t have the affirmative obligation to provide liquidity at all times. The fact that they generate more than 90% of the market’s quotes, but only half its actual trade volume shows they are canceling a huge amount of listed quotes even if a valid offer was made for the shares. Since such cancellation is allowed on most exchanges, using false quotes to obtain information on stock demand and supply from other market participants is a typical HFT tactic.
The upshot of such behavior is that it makes real market makers less willing to provide liquidity. When there is insufficient true liquidity in a market, accidents can spiral out of control, as they did in the “flash crash” of May 6, 2010. In the course of minutes, the U.S. stock markets dropped by 9%, then recovered. During the crash, individual stocks traded at impossibly wide spreads. Clearly, the market makers hadn’t done their jobs, and the SEC determined that many participants (HFTs) had pulled their quotes when things got messy, thereby exacerbating the problem and proving that they do not represent true liquidity. While crashes were always possible under the old system, the activity during the flash crash was different, more random and, to us, more disturbing.
So basically, HFTs exist merely to skim profits off transactions that would have happened anyway, without their presence. Why should we care? Ironically, in our reading of Flash Boys, the HFTs don’t really come out as villains. They represent only themselves, and spend their own capital to obtain a speed advantage in a world where even the tiniest fraction of a second makes a difference. As far as we understand, none of their actions are illegal (although investigations are underway). Obtaining an informational advantage through speed didn’t start with HFTs; it’s a tactic as old as the markets. So, one could view them as harmless parasites. Interestingly, Michael Lewis makes the big banks look much worse than the HFTs. The banks determined they couldn’t compete with the speed of the HFTs, and that the only value the banks possessed in the new market was their customers’ trade-related information, which the banks considered their own. So, they sold HFTs access to their dark pools for huge sums. This allowed HFTs to front-run the banks’ clients. Legal or not, the morality of such behavior is clearly suspect.
In our opinion, the money HFTs take from long-term investors is irrelevant. After all, middlemen have always taken a cut. We would argue that they are less useful than the traditional Wall Street middlemen, who took real risk with their own capital by holding inventory and providing true liquidity. But the old-timers were better compensated for their risk via a large spread, so individual investors now have lower overall execution costs than before. And at some level, too, it seems as though the HFTs have become victims of their own success. Their business models depend as much or more on beating out each other–as well as individual investors and large banks–and that gets expensive. In a world of narrow spreads, traders can only make profits on heavy volume, and since the flash crash, stock market volumes have dropped 50%. A statistics professor at Purdue University has estimated that industry-wide profits for HFTs have dropped from $5 billion in 2009 to $1.25 billion in 2012. Extensive data is extremely hard to come by, but if the trend is accurate, some HFTs will decide it’s not worth their effort anymore.
Putting all that aside, nothing any HFT does has any impact on the fundamentals of the companies in which BTR might invest for our clients. Stock prices will always be volatile, even on an intra-day basis, such that the timing of a buy or sell can have much more impact than whatever an HFT might do in the few seconds after we enter an order. To us, the point of “investing” is that we’re in it for the long haul. Our investment time horizon for an individual stock is measured in years, not microseconds. Even if an investor does lose a fraction of a penny per share to an HFT on a 200-share trade, if he has a portfolio of 35 stocks and we execute 20 trades a year, the cost is negligible. We do believe that since spreads have compressed over the past decade, our clients are better off, and because BTR is a relatively small institution, a market characterized by more frequent trading in smaller blocks is actually better suited to our business. What is most important is having a plan and only altering it as one’s circumstances change, not as the market fluctuates. Since the flash crash of 2010, household ownership of stocks has dropped from 67% to 52%, but for those who remained invested, the S&P 500 has returned more than 75%. We needn’t cry over the pennies.
The real risk posed by HFTs is that they could contribute to a much greater market calamity than the flash crash. Circuit breakers have been instituted to halt major declines, first at the market level (after 1987) and then at the individual stock level (after 2010). Still, the circuit breakers didn’t prevent Knight Capital from losing $10 million per minute one day in 2012, when an algorithm went rogue. It took the company 44 minutes to identify the problematic code and kill it. According to Mr. Lewis, there were twice as many stock market “outages” in the two years after the flash crash than in the ten years before it, a clear sign that the overall system’s complexity has increased. We believe on balance that the system would be better off without so many computer programs running the show. One proposal to limit high-frequency trading activity being contemplated in Europe and the U.S. is to institute a small financial transaction tax. Again, it would be insignificant to a true investor, but would remove a chunk of the already tiny margin HFTs earn per transaction. Perhaps, simply placing a tax on canceled quotes would work. That way actual market makers and their customers would be charged almost nothing and listed bids and offers would more accurately reflect true market demand and supply.
Little has changed since our last Investment Strategy Update. The situation in Ukraine has escalated but so far remains a minor influence on the U.S. stock market. Earnings season brought a fair amount of disappointment, but to the extent any underperformance was due to weather, companies are being given a pass. GDP growth was a dreadful 0.1% in the first quarter and the stock market barely reacted, which means the weakness was already priced in. The economy is expected to accelerate strongly in the second quarter, however, so failure to do so represents a risk to the market.
Interest rates do seem to be reflecting some of the first quarter economic weakness, but that also should be temporary. The stock market is marking time, for now, and may continue to do so through the summer, but if economic growth proves resilient, we believe it could drag hesitant investors into the market and turn 2014 into the decent year which we have been expecting.