Small investors vs high-speed traders

By Felix Salmon
August 7, 2012

One of the problems with financial journalism is its rather kludgy attempts to appeal to a general audience. If something bad happens, for instance, it has to be presented as being bad for the little guy. This was a huge problem with the Libor scandal, since anybody with a mortgage or other loan tied to Libor ended up saving money as a result of it being marked too low.

But don’t underestimate the imagination of the financial press. For instance, what if there was a New York county which put on Libor-linked interest rate swaps to hedge its bond issuance? In that case, if Libor was understated, then the hedges would have paid out less money than they should have done — and presto, the Libor scandal is directly responsible for municipal layoffs and cuts in “programs for some of the needy”.

This is all a bit silly. The Libor understatements actually brought it closer to prevailing interest rates; the fudging basically just served to minimize the degree to which the unsecured credit risk of international banks was embedded in the rate. And in any case, the whole point of a hedge is that it offsets risks elsewhere: it’s intellectually dishonest to talk about losses on the hedge without talking about the lower rates that the municipality was paying on its debt program as a whole.

We’re seeing the same thing with the fiasco at Knight Capital, where a highly-sophisticated high-frequency stock-trading shop lost an enormous amount of money in a very small amount of time, and small investors lost absolutely nothing. On the grounds that we can’t present this as news without somehow determining that it’s bad for the little guy, it took no time at all for grandees to weigh in explaining why this really was bad for the little guy after all, and/or demonstrates the need for strong new regulation, in order to protect, um, someone, or something. It’s never really spelled out.

The markets version of the Confidence Fairy certainly gets invoked: Arthur Levitt, for instance, said that recent events “have scared the hell out of investors”. And Dennis Kelleher of Better Markets goes even further: I was on a TV show with him last night, where he tried to make a distinction between “high-frequency trading” and “high-speed trading”, and said that shops like Knight rip off small investors. He’s wrong about that: they absolutely do not. Yes, Knight and its ilk pay good money for the opportunity to take the other side of the trade from small investors. But those investors always get filled at NBBO — the best possible price in the market — and they do so immediately. Small retail investors literally get the best execution in the markets right now, thanks to Knight and other HFTs. And those investors want companies like Knight to compete with each other to fill their trades as quickly and cheaply as possible. If Knight loses money while doing so, that’s no skin off their nose.

So Andrew Ross Sorkin is right to treat such pronouncements with skepticism. The argument that “investors are worried about high-frequency trading, therefore they’re leaving the market, therefore stocks are lower than they would otherwise be, therefore we all have less wealth than we should have” just doesn’t hold water at all. Sorkin has his own theories for why the stock market doesn’t seem to be particularly popular these days, which are better ones, but the fact is — he doesn’t mention this — that the market is approaching new post-crash highs, and that if investors follow standard personal-finance advice and rebalance their portfolios every so often, they should probably be rotating out of stocks right now, just to keep their equity holdings at the desired percentage of their total holdings.

The calls for more regulation are a bit silly, too. Bloomberg View says that “if any good comes out of the Knight episode, it will be a commitment by Wall Street’s trading firms to help regulators design systems that can track lightning-speed transactions” — but regulators will always be one step behind state-of-the-art traders, and shouldn’t try to get into some kind of arms race with them. More regulation of HFT is not going to do any good, especially since no one can agree on the goals the increased regulation would be trying to achieve. If what we want is less HFT, then a financial-transactions tax, rather than a regulatory response, is the way to go.

I do think that the amount of HFT we’re seeing today is excessive, and I do think that we’ve created a large-scale, highly-complex system which is out of anybody’s control and therefore extremely dangerous. Making it simpler and dumber would be a good thing. But you can’t do that with regulation. And let’s not kid ourselves that up until now, small investors have been damaged by HFT. They haven’t. The reasons to rein it in are systemic; they’re nothing to do with individuals being ripped off. Sad as that might be for the financial press.

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