Friday, April 04, 2014

HFT is not an act of nature

The FT reviews Michael Lewis' new book, "Flash Boys" and ends on this note:
Indeed, as Lewis explains, much of their behaviour was perfectly in line with regulations – the Securities and Exchange Commission deliberately tried to weaken the monopoly power of large exchanges to create more competition. It may not have appreciated the scale of what it would unleash – 13 public stock exchanges and more than 40 private “dark pools”.

And financial trading is not the only ecosystem that is highly complex and aggressive. “I would ask the question, ‘On the savannah, are the hyenas and the vultures the bad guys?’ ” says one of Katsuyama’s more dispassionate colleagues. “We have a boom in carcasses on the savannah. So what? It’s not their fault. The opportunity is there.”
The analogy with the jungle is telling because it presupposes that HFT, or the environment that created HFT, is simply an "act of nature" and thus being "natural" beyond this type of moral scrutiny. But markets are not "natural" -- they are constructs put together for public purpose (to use Mosler's term) and our equity markets are no different.

HFT seems so plainly on its face to be an exploit of the system, and it makes it difficult to defend it publicly, and it is this reason why I think the "only natural" argument seems to weak. The FT itself points out this contradiction because, one paragraph before declaring it "natural" it says that this came about because of changes in SEC regulation a little earlier.

The stronger arguments about liquidity and tighter spreads are more compelling, but I think Lewis makes a good case by distinguishing between liquidity and activity. Liquidity comes from players willing to take the opposite sides of trades when things are going south, not withdrawing from the market altogether, and there are few institutions capable and willing to do that at all times. I don't think HFT algorithms can be counted amongst that number either. Ultimately, I think only the government can reliable act in a truly counter-cyclical manner.


Blogger jb said...

You and Lewis are both wrong. You don't understand what is going on. You say, "HFT seems so plainly on its face to be an exploit of the system." But if retail investors/traders are getting better prices for their orders how are they being exploited by this technology?

For example, if a retail trader wants to buy a stock on the offer, and sell on the bid, and gets a slightly better price on both trades how is HFT hurting him? The real bottom line is that competition for order flow by HFT firms means price improvement for retail traders. Again, can you explain how that is a bad thing? Watch at 18:18 mark of the video at - to demonstrate what price improvement means on the majority of retail trades.

9:13 PM  
Blogger jb said...

FYI - Vanguard chief, Bill McNabb, defends high-frequency trading firms

8:29 AM  
Blogger jb said...

One more interesting FYI -
Kid Dynamite's Blog:
High Frequency Trading: The Little Guy is the Big Winner

6:44 AM  
Blogger winterspeak said...

Hi jb

Thanks for all your thoughts on this. On many items we are agreed.

For the record, I don't think the major victim of HFT is small time traders -- I think it's institutional investors who trade in sufficient quantity that this stuff becomes material. Indirectly, to the degree that these guys are managing pensions funds etc. it does impact the little guy, but the impact is quite indirect.

If I was one of those investors, I would want a differently structured exchange to trade on, so we'll see if IEX lives up to it's promise.

From a policy standpoint, if I were a regulator, I would see HFT as an unintended consequence of exchange regulation a few years ago, which is certainly not the first time that has happened. I would then ask myself if it's something the market can deal with (via IEX, and margin contraction) or if I should intervene because it is close enough to front-running (which is currently illegal) to merit a regulatory action. I personally would come down on the "front running side" because I've found the liquidity arguments unconvincing, and I have neither a laissez-faire nor regulatory bias, but others may certainly see things differently.

11:05 AM  

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