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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Comments
23 comments so far

Best ever post, Felix!

Posted by TFF | Report as abusive

Very true, Felix. And it’s not just the financial press. And this site is also occasionally guilty; I seem to remember a recent diatribe about how, um, hamburgers were causing great havoc.

Posted by Curmudgeon | Report as abusive

“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””

The market isn’t some magic wealth fairy that makes wealth out of nothing. We need markets to make sure capital flows to where it is needed, but they already do that and then some.

Posted by QCIC | Report as abusive

Far be it from me to rain on this parade of well-deserved congratulations for FS, still –

HFTs get in the middle of a transaction between a real buyer, who wants to buy what and a real seller wishes to sell, right? HFT’s never hold anything they buy for even a full second, do they? AIUI, it’s the real buyer and the real seller who do get together, but the HFT sort of brokers the transaction – for a cut.

If the HFT didn’t take that cut, one (or both) of the real parties would, it seems – or maybe someone else, a market maker of a different sort, perhaps. For HFTs to make money somebody has to pay it to them. Tell me the retail investor ever escapes that payment. Maybe it’s a good deal for the retail-types – maybe all other options are more costly. IDK, but it doesn’t feel right – and considering how much money HFTs pocket, it sure as hell can’t be cost-free, can it?

Posted by MrRFox | Report as abusive

Can’t fix the problem through regulation? Requiring bids to be valid for one second would do it. A small transaction fee would too.

Posted by ScottFree | Report as abusive

You can’t do that with regulation? Of course you can. The easiest thing in the world for regulation to do is to “ride the brake” and slow down the velocity of money.

It’s one of the the things Wall Street most commonly complains that regulation does.

A regulation that prevents HFT frontrunning would slow down trading speeds immensely. Just state that no trade can be completed in under 30 seconds. Sure, traders will still be able to detect trends in pricing, but they won’t be able to use latency-based frontrunning to take advantage of it, so they will have less reason to get in there and so will reduce the speed of price movement.

Most of all we need to get past the idea that HFT provides liquidity. They aren’t selling anything that they couldn’t re-buy elsewhere in mere seconds anyway. They’re just middlemen as MrRFox points out above.

Posted by stereoscope | Report as abusive

@MrRFox, my impression is that in the past that cut has gone to human market makers.

Figures I’ve seen are less than $10B/year, and I doubt that the increased activity is generating higher total profits. More likely just shaving the penny more different ways. That compares against ~$1T of profits annually for the S&P500 and ~$15T US GDP.

Doesn’t seem like a huge cost to me, and I’m not at all convinced that the function can be performed more cheaply without dramatically altering the system.

Surely can be designed in a more stable fashion, however.

Posted by TFF | Report as abusive

Isn’t it the case that the HFTs’ machines get to the buyer’s and the seller’s machines faster than the parties’ machines can get to each other? If that didn’t happen, the buyer and seller would split all the money in the deal. By getting there first the HFTs capture a cut before the parties can share it.

Sure, the parties have to pay something for the platform that enables them to get together. They pay comms on their transactions. Isn’t that enough?

Posted by MrRFox | Report as abusive

MrRFox, the buyers don’t communicate directly with the sellers. They work through exchanges.

Not quite sure where to look for trading volumes, but I get the impression that it is on the order of 1 trillion shares per year. Seems the “tax” of HFT is less than a penny per share. Less than I typically pay in commission on a trade.

I’m not excusing or defending HFT, just suggesting it isn’t that big a deal. Unlike the estate tax.

Posted by TFF | Report as abusive

The problem isn’t that HFT causes individual investors to lose money, it’s that HFT has the potential to cause massive instability in the markets because trades take place faster than humans can react(remember the flash crash, anyone?), thus eroding investor confidence in the markets.

Posted by mfw13 | Report as abusive

“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.”

Assuming that was the case. Sometimes it was low, sometimes not, depending on the goal the traders had for the day. The strategies shifted over time. But obviously, _someone_ was getting cheated, even if it wasn’t always Joe Average Homeowner.

Posted by Moopheus | Report as abusive

Bovine Scatology.

When we are talking about the complex financial instruments of the sort that involve LIBOR and HFT, they are zero sum gains. To the degree that banksters win, the rest of us lose, even if just by chasing capital from constructive uses to the big casino.

In the case of HFT, it is even clearer: HFT is front running on a microsecond scale. They execute short term trades and collect a toll on the rest of us.

In both cases, there are simple dumb regulations that can ameliorate the situation.

In the case of HFT, requiring trades to be executed, and requiring that the trade duration is longer, and in the case of LIBOR, requiring that loans be cleared on a government operated exchange with immediate public disclosure.

Good regulation is easy: You simply have to make it dumb. The banksters will cheat on the smart stuff, because they CAN, and because their bonuses depend on it.

Posted by Matthew_ | Report as abusive

Good post, Felix. You nail one of the problems with financial journalism, and the other one is that most financial journalists don’t seem to understand very much about finance or business, and the closer one gets to the mainstream the more pronounced this problem becomes.

Posted by realist50 | Report as abusive

Here are some ways HFTs hurt small investors:

+By ensuring that the spread goes to professional traders rather than to other naturals. This was one of the primary justifications for the deregulation of the specialist market. Intermediation rates used to be in the high teens or low 20s. Today, they’re 50% or more. Pragma Securities has a research note on just how much this costs institutions, and, by extension, the public. See http://www.pragmatrading.com/sites/defau lt/files/pragma_commentary_hft_and_cost_ of_deep_liquidity.pdf;

+By using the enhanced data feeds exchanges supply to HFT firms so HFT firms can trade off of order information. To be sure, other firms buy these feeds, but they were originally designed in hand with HFT firms, and these firms well knew they could use them to predict very short-term price movements and profit from them. This style of order information trader is just an old-fashioned scalper, often takes more liquidity than it supplies, and is a tax on all investors. For more details on just one strategy using these feeds, see http://papers.ssrn.com/sol3/papers.cfm?a bstract_id=2004231. See also https://www2.bc.edu/~taillard/Seminar_sp ring_2012_files/Hirschey.pdf;

+By generating excessive and largely meaningless quote traffic, socializing many costs of HFT strategies while of course keeping HFT profits private. This is different from deliberately manipulative strategies like “quote stuffing” and is simply the ever-increasing technological cost of handling HFT chaff. See http://blogs.reuters.com/felix-salmon/20 12/08/06/chart-of-the-day-hft-edition/;

+Through manipulative strategies like quote stuffing, which, when inadvertent, at minimum cause collateral damage throughout the market – and when deliberate surely are used to pick pockets. See http://papers.ssrn.com/sol3/papers.cfm?a bstract_id=2066839;

+By introducing another element – time at the millisecond level – as a complexity and game variable used to extract rents from longer horizon investors. See http://papers.ssrn.com/sol3/papers.cfm?a bstract_id=1924991.

+By introducing higher levels of volatility. See http://papers.ssrn.com/sol3/papers.cfm?a bstract_id=2022034.

So there are many costs passed on to longer-term investors, large and small, either directly to anyone who manages his or her own assets, or indirectly to anyone who invests through an institution.

Posted by MErskin | Report as abusive

The Fed governors can levy a transaction fee on anything connected to the banking system (which is to say, everything).
They could levy a financial transaction fee or simply announce a fee that’d only apply to exchanges that don’t institute their own HFT fee. Easy-peasy, a majority of the Fed governors can vote to update their fee schedule a bit faster than Congress can vote to amend the Internal Revenue Code (increasing what Fed rebates to Tsy in the process).
Of course taken to its logical extreme, the Fed could more or less replace the IRS as Tsy’s revenue collector (UW-Madison Econ professor Edgar Feige proposed as much with his Automated Payment Transaction tax).

Posted by beowu1f | Report as abusive

Two wrongs and a right:

“But those investors always get filled at NBBO — the best possible price in the market — and they do so immediately.”

Wrong, B/Ds have significant leeway to fill outside the NBBO and the whole point of many HFT algos is to manipulate the NBBO anyway.

“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.”

You’re not happy if your IRA had a stop-loss on in one of the names NITE temporarily cratered.

But yes, the LIBOR “scandal” is a joke. It more or less exactly tracks Fed funds anyway – the favorite tool of centrally planned ZIRP which will royally screw millions and millions of people in the end.

Posted by MercuryZH | Report as abusive

We used to pay specialists a lot of money to damp down this volatility — and I’m not sure that critics of HFT are accurately considering the cost of that system. It doesn’t help that the flaws of the current electronic system are much, much more visible.

Maybe someone will attempt a more systemic cost comparison soon. . .

Great piece.

Posted by THamacher | Report as abusive

@TFF, @ Curmudg – about the first and second posts in this thread -

Really, TFF? Curmudg – IMO it’s not quite fair to compare this piece to that Amtrak burger-fetish bit, which actually had something (thin) to it. Seems more appropriate to put it in a class with, and second-only to, that (thankfully passing) infatuation someone had about finding a ‘free lunch’ through creative Target2 default accounting. (Ugh!)

Posted by MrRFox | Report as abusive

It seems like the anti-HFT crowd imagines a market with no middleman, where buyers and sellers can meet at the midpoint of their price range and there is no cut for a 3rd party intermediary.

Looking at markets other than stocks, does this seem realistic? Real estate professionals take huge cuts out of real estate transaction volume, even when they do very little work. Everyone is mad when they have to pay the fee, but no better system has been invented. Ebay takes a huge cut on auctions, even though they are just a listing service where the user has to do all the work. People complain, but no one has created an effective and free or cheaper competitor. Car salesman make a nice living for providing the service of “Oh, you would like to buy a Prius? Well, fortunately we are a Toyota dealership so we can get you one in a month, as long as you like yellow. Pay me!” Diamond rings have a huge retail mark-up built in, but a large fraction of grooms pay this mark-up rather than finding the owner of an existing diamond who wants to sell. I could go on.

In this framework, HFT looks pretty good. If you want to buy 100 shares of IBM and it’s trading around 190 all week, you can go into the market and pick your limit price in the 190 neighborhood and get your shares quickly, paying an implicit price of a pennies per share to your intermediary. You’re not paying 6%, as you do in many other markets and as stock traders used to (look up what brokerage fees were in the 70s). It’s not like Knight Capital and its peers were making gangbusters profits before its misstep – the remaining market-making-type firms are survivors in an industry where many older firms have gone out of business due to profits drying up due to more efficient markets.

Posted by najdorf | Report as abusive

What do you mean, why should I pay even pennies to an HFT?

They are not providing shares to buy. They don’t hold anything. If I can buy it from them, then I could have bought it from someone else, the same person they did, within seconds of when I got them.

Why should I pay a guy even pennis for holding onto a stock for a second? The brokerage fees may have been higher in the 70s, but at least those companies charging fees actually were making markets in the shares. They held shares and took risks in holding them. HFTs only hold them for mere moments.

Posted by stereoscope | Report as abusive

Why do people have the impression that HFTs hold onto all positions for a second? It is usually many minutes, often hours. That they _can_ hold a position for a few seconds is not the same as _do_.

Posted by m_m | Report as abusive

@najdorf, isn’t the exchange the stock trades on playing the part of the salesman in your example? If I buy a stock, I’m not calling up an HFT shop to buy it, I’m posting a transaction on an exchange the same way that the seller is and it’s the exchange that pairs us.

As far as my understanding goes, your example would be more accurate if you had alluded to showing up at a dealership looking for a Toyota and some other guy was following you around, waited until you settled on a car, and then jumped in front of you to buy it. He then turned around and sold you the car for a slight markup. The same with the Ebay example. Ebay’s part is played by the exchange. The HFT is the sniper who buys the product right at the buzzer and then turns around and offers to sell it to you for one extra penny.

Maybe it’s just my lack of financial sophistication but I still don’t understand how that is helpful.

Posted by spectre855 | Report as abusive

I agree with another post futher up the thread,HFT’s do not always hold on to postions for just seconds scalping the market ,it can be minutes ,it all depends on the trading system they are using.Some traders open between 15-20 position at a time and can remain open for hours if the market volumes are low. Nidal Saadeh UK

Posted by SAADEH | Report as abusive
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