The HFT debate

By Felix Salmon
April 1, 2014

CNBC might be guilty of a tiny bit of hyperbole when they say that their HFT debate today, between the CEOs of rival exchanges IEX and BATS, “stopped trading on the floor of the New York Stock Exchange” and “Twitter stopped too”. Still, they undoubtedly caused a lot of buzz, and the debate — coming, as it does, in the wake of the release of Michael Lewis’s new book on the subject — is an extremely important one, and it is indeed of great interest to that most endangered of species, the NYSE floor trader.

Because CNBC lives on maximizing cacophony, the debate ultimately created more noise than illumination. But at least there was a debate, which is great: it’s very important to get these people talking at the same venue, because if that happens often enough, they might conceivably stop talking at cross-purposes to each other, and maybe even start agreeing on some useful changes which can be made to market structure.

There is the potential for finding common ground here. Brad Katsuyama, the founder of IEX and the hero of Lewis’s book, is no white-hat absolutist: he doesn’t like the way in which the term “HFT” is used to cover a multiplicity of different behaviors, and in fact he is all in favor of computerized trading. (Which makes sense, seeing as how he runs a dark pool.) And BATS president Bill O’Brien is happy to concede that the market has become too complex. He said only that the complexity needs to be “managed”, rather than simplified, but in reality simplification is by far the most effective way to manage complexity. A market with only three or four order types, for instance, is a lot simpler and easier to manage than a market with hundreds.

Can the market be fixed? Michael Lewis says he would like to see that — but at the same time he says that he welcomes the way in which the FBI and the New York attorney general are launching investigations into HFT, to see whether anything in that world can be considered criminal insider trading or market manipulation. My feeling is that if you want prosecutions, then law-enforcement should launch investigations — but that if you really want to fix things, then creating a highly adversarial relationship between HFT shops and the government is not going to help and is in fact almost certain to hurt.

After all, a long sub-plot of Lewis’s book concerns the way in which law enforcement is completely clueless about high-frequency trading, and ends up jailing the innocent rather than doing anything constructive. HFT is very, very hard to understand, and trying to break it down along legal/illegal lines is unlikely to be helpful. If we want to make markets safer both for big real-money investors and in terms of the system as a whole, then the exchanges, along with their HFT paymasters, need to be part of the solution, rather than lawyering up and entering a defensive legal crouch.

And frankly the buy side — which gets a complete pass in Lewis’s book, as the guileless victim — needs to be part of the solution as well. Right now, most investors’ orders are passed to certain broker-dealers not on the basis of which broker offers the best execution, but rather as part of a “soft dollar” system which rewards good research, access to IPO roadshows, and the like. In other words, it’s not traders who decide which brokers to use — it’s portfolio managers.

Most invidiously, soft-dollar fees are paid out of brokerage commissions — which is to say, they’re paid by the investors in the funds. If the system moved to a hard-dollar fee-for-service approach, where traders were incentivized to use the brokers with the best execution, then those fees would be taken out of the management fees which are currently being pocketed by the portfolio managers. And it turns out that portfolio managers are much happier paying commissions out of their investors’ money than they are out of their own income.

All of which is to say that fixing the market will take a lot more than just the FBI coming in with a blunderbuss. It will mean deep reform across a huge swathe of the financial markets, some of it seemingly far removed from HFT. Which in turn means that I’m not holding my breath.

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