It has certainly been an interesting few weeks for traders around the world: since Michael Lewis’ book “Flash Boys” was published, the financial markets, and high frequency trading in particular, have hardly left the headlines.
I’d characterise the reaction of many traders I talk to about the topic as a combination of bewilderment and frustration: bewilderment, because we’re not used to receiving such levels of public attention, given that our field is complex, specialist and technical in nature. Plus ours are proprietary trading firms: this means we trade using our own money, and don’t have customers, per se. So we’re not used to broad public dialogue, beyond providing the information frequently sought by regulators and with exchanges and other market participants.
Frustration, because we can’t reconcile the picture painted by Lewis with our own view of the role we play in the market. As Bloomberg’s Matt Levine describes in his ‘alternative Michael Lewis scenario’, our industry has always viewed itself as the young, challenging upstart in the story of the markets. The David to the major trading firms’ Goliath, who through the application of brainpower, computer wizardry and investment, have brought modern technology to the markets. And in doing so turned trading into a meritocracy, delivered vast liquidity and driven down trading costs to the benefit of all market users.
To find out that, despite doing all of this, we’re cast wearing black hats to the IEX dark-pool’s John Wayne, has somewhat disturbed our world view.
Luckily for our sanity, it seems we’re not the only people to think this way. Rumbling underneath the hyperbole have been some interesting and well thought-out responses to Flash Boys and the debate it’s started – some of which we’ve collected together in this article.
Mr Lewis fundamental claim is that the market is ‘rigged’, and yet, since its publication, there have been statements representing every kind of market participant (as well as the SEC) to say that it is not. Even Richard Gates (TFS Capital) who is featured in the book for having made his own investigations into what was happening in the market says that the book is several years behind reality: “I think the markets are stronger than ever. A lot of these issues have been resolved.”.
Michael Lewis seems to have toned down his opinions since arriving in Europe at the end of April, now saying (on BBC Radio 4’s today programme) that 50% of high frequency trading is beneficial to the market and adds value, which is a slightly more balanced view than his central, ‘rigged’ thesis.
Perhaps this change in tone is in response to statements from many of the world’s largest institutional investors (the buy side who Michael Lewis claims to be defending from high frequency traders), who have gone on record to suggest high frequency trading has provided benefits to the market:
"How do we feel about high-frequency trading? We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars."
Cliff Asness, AQR Capital Management
“[Electronic market making] brings tangible benefits to our clients through tighter spreads"
BlackRock paper on US Equities market structure
“High-frequency trading in general has been good for the retail investor,”
Fred Tomczyk, CEO, TD Ameritrade
“From a data perspective, we can see what’s happened to our fund shareholders over the last 20 years and they’ve benefited by that reduction in transaction costs.”
Bill McNabb, CEO, Vanguard
"HFT is not unlawful insider trading. It allows you to react quicker. If HFT is properly used, it is not insider trading."
Mary Jo White, SEC Chairman
“Electronic market making is a crucial element of the market and firms that take on risk even at low latency to make markets liquid should be rewarded,”
Matt Lyons, Capital Group
In “Flash Boys”, Lewis claims that high frequency traders are “illegally front-running” other market participants (particularly large buy side orders) because they “know” when large trades are about to be placed, so they get in ahead of the trade, and then sell it back at a higher price when the large trade eventually hits the market.
First of all, as has been expressed by other writers, front-running is a legal term with a clear legal definition: not the definition being used in “Flash Boys”. Front-running in the defined sense can only happen when a market participant with a fiduciary duty to act as your agent (i.e. who you are paying to execute trades on your behalf) uses knowledge of your trades to make their own trades (and thereby profit at your expense). As principal trading firms (often described as HFTs) trade solely with their own capital they do not act as agents (i.e. do not have customers of their own). “HFT front-running” is therefore something of an oxymoron.
Lewis confuses the concept of illegal front-running of client orders with the competitive advantage of speed in receiving and processing publicly available market data faster by virtue of investing in a direct connection to exchanges (an option accessible to all market participants). Due to these direct connections, some firms can post bids and offers faster than slower traders. This is legal and competitive – and I’d suggest ‘fair’ (if competition in itself is deemed fair).
It seems to me there’s a parallel with Lewis’s own trade, journalism. Investment in the network infrastructure (reporters on the ground, intelligence networks, broadcasting technology) to be the first to report a breaking story is the most fundamental competitive strategy to draw an audience. Is getting and acting on the information first unfair?
As high frequency traders have bids and offers posted in a wide range of markets throughout the trading day it is likely that a high-frequency trader will often be “at the front of the queue”. This is purely based on information from commercially available data feeds that can be purchased by any market participant. This presence “at the front of the queue” is not, as Michael Lewis alleges, because of some prior knowledge of the orders being placed on the exchange. No exchange in the world allows one set of traders to see orders before they hit the matching engine: that would be illegal, and would be dealt with accordingly – and we would support that.
In the first few years of fragmented markets it was sometimes difficult for investors to access the available liquidity on multiple platforms, mainly because market makers would adjust their quotes as soon as they saw a price move on another exchange (which would happen rapidly because of the direct connection). This is simply market-makers doing their job: maintaining consistent prices across a fragmented market.
In spite of its flaws, we hope that “Flash Boys” will provide an excellent opportunity to discuss the current market situation and to work, together with all market participants and regulators, to ensure that the shape of the US marketplace reflects the modern market technology utilised by an ever-increasing percentage of the markets. It’s also a bit of a wake-up call, for our industry to be less introspective, and stop taking our own view of the world for granted.
The views expressed in this blog post are the personal opinions of the author and do not necessarily reflect the official policies or positions of the FIA European Principal Traders Association or the Futures Industry Association.
