THE PUBLICATION of Michael Lewis’s book Flash Boys has understandably turned the spotlight onto high frequency trading (HFT). A cacophony of voices repeating catchy sound bites about markets being “rigged” against average investors have forced the Twitter decibel level to “11”.
If the noise translates into book sales and the rumoured movie deal comes to pass, Lewis will have done well. But as the sense of hysteria dies down, it’s worth considering whether the characterisation of HFT is accurate. One point of contention is not only that “HFT firms” are to blame for the market’s woes – but that they exist as a category at all.
The reality is that HFT is a technology, not a type of company. HFT describes the use of low latency connections to exchanges, such as co-location, which allows traders to send high volumes of messages to post orders and to manage their risk. These technologies can be used in the execution of any trading strategy and are now an integral part of the market, employed by many types of market participant (including proprietary firms, buy-side, and investment banks).
Perhaps the companies who make the most use of HFT are market makers, so a more useful question to debate would be whether or not we need specialist market making firms. We take for granted that we can buy or sell a stock at a moment’s notice. Without market makers to take the other side of a trade, there would be far fewer participants interested in that trade – and investors wouldn’t be able to buy and sell stocks whenever they wanted.
Market makers offer quotes in multiple equities across trading venues, so investors can trade at the price they want, on the exchange they use every day. By trading in multiple markets simultaneously, market makers are able to monitor and keep prices consistent across trading venues. This is a crucial part of the market maker role. By making prices, however, a market maker opens himself up to the risk of losing to informed traders who know more about asset values. That’s where HFT comes in as a necessary tool, enabling market makers to update their quotes quickly enough to limit their exposure when prices become stale.
Without market makers, equities would be less liquid, prices more volatile, and the market, without the speed and accuracy of the price discovery process and lower transactions costs made possible by HFT, would be all around more expensive to trade. So although a market maker may earn a fraction of a cent on trades, the investor saves substantially more than this in their overall costs.
Speed is, and always has been, a form of competitive advantage for traders. Any market participant can choose to invest in high-speed trading technology, but even if they do not (because speed is not an essential component of a long-term investment strategy), they still benefit from the more accurate pricing and increased liquidity it brings.
Many investors state that they have seen clear evidence of this. In a 2010 US Securities and Exchange Commission comment letter, Vanguard (one of the world’s largest mutual funds) “conservatively” estimated that transaction costs had decreased by 0.5 percentage points per side, or 1 percentage point per round trip. If we extrapolate, this means that an actively-managed equity mutual fund with a 100 per cent turnover ratio currently producing a 9 per cent return would have returned only 8 per cent in the years before HFT.
An investor would see a $10,000 (£5,900) investment grow to $132,000 over 30 years at 9 per cent, compared to $100,000 at 8 per cent – a 30 per cent difference in the end value of the portfolio. These savings are due to efficiencies as a result of modern market technologies and electronic market-making practices.
Fortunately, European legislation treats HFT as a tool used by lots of different market participants, not just one group, with dialogue addressing market structures in general, and trading behaviours of all market participants. The European Parliament’s vote on the Markets in Financial Instruments Directive II, which also recognises the essential role of market makers, comes at a good time to bolster confidence. It’s a clear signal that Europe has already committed to creating effective, well-regulated markets; indeed it has been working towards this goal for years.
So while Michael Lewis claims that markets are “rigged,” we believe they are fairer today than ever. You no longer need to be part of the right “club” with an expensive seat on the trading floor to start trading. All you need is a computer.
Johannah Ladd is secretary general of the FIA European Principal Traders Association.