Sunday, 20 April 2014

Flash Boys Provides Useful Reality Check

Michael Lewis new book, Flash Boys, has focussed mainstream attention on the benefits and costs of High Frequency Trading. HFT has transformed global equity markets over the past decade. Despite its critics, the book is a must read for anyone who has a significant stake in the equity market, either directly through a personal equity portfolio, or indirectly through mutual funds, ETFs or pension funds.

Lewis' claim on CBS "60 Minutes" that HFT firms have "rigged" the stock market at the expense of individual investors certainly attracted widespread attention.  It will be unfortunate, however, if the headlines about the book only succeed in eroding further already weak public confidence in financial markets. If, on the other hand, investors (and the mutual funds, pension funds and bank owned brokers who act on their behalf) read the book, do their own research, and demand protection from predatory HFT practices and those stock exchanges that encourage them, then the result can be increased confidence in the fairness and stability of equity markets.

Flash Boys is a well-told story that provides compelling reading and valuable education on how HFT developed and how, in some cases, it has been misused. It recounts how stock trading has been transformed, in the wake of the 1987 crash and the bursting of the Tech Bubble, from markets anchored by human market makers into a markets operated by high speed computers.
  • It explains why it made sense for Spread Networks to spend $300 million to lay fibre optic cable in as straight a line as possible to shave 3 milliseconds off the communication time between Chicago's equity futures market and New York's stock market. 
  • It explains how bank-owned brokers may use their own HFT dark pools to trade against their own customers or sell that opportunity to faster, predatory HFT firms.
  • It explains why stock exchanges can sell at high prices the right to co-locate the servers of HFT firms within close proximity to the computer "matching engines" of the exchange, thereby creating a speed and information advantage over non-HFT investors.
  • It explains why a simple system of market orders and limit orders that sufficed for decades has been supplanted by a system with over 30 different types of orders, some expressly designed to enable HFT to front run trades of non-HFT investors. 
  • It explains why increased HFT's increased share of total trading can actually reduce liquidity and increase intraday volatility of the stock market.
Defenders of HFT claim that the proliferation of private stock exchanges and HFT firms has reduced trading costs and increased liquidity of equity markets. But Flash Boys casts serious doubt on these claims. The advent of electronic trading and decimalization of stock prices are probably responsible for the lion's share of the the reduction in trading costs over the past decade. The explosion of HFT seems to have merely increased the frequency of partial fills on larger orders and unnecessary price movement that benefits high speed predators.

From my perspective, the most fascinating insight drawn from Flash Boys, is that investors, even large pension funds and mutual funds, cannot compel their bank-owned brokers to direct their trades to the stock exchange of their choice. Once the non-HFT investor pushes the buy or sell button for a market order, he/she loses control over where and how the trade is executed and permits the broker to sell the information contained within the order to HFT firms.

It's not just Michael Lewis and the Flash Boys cast of characters who are asking questions about HFT. Two years ago, the Investment Industry Regulatory Organization of Canada (IIROC) was already investigating these questions:
  • Is displayed order flow by HFT too fleeting?
  • Is the liquidity provided by HFT illusory?
  • Does HFT exacerbate volatility?
  • Does HFT seek informational advantages over other investors - retail and institutional - through their trading strategies?
After reading Flash Boys, it seems obvious that the answer to all of these questions is yes. What seems wrong with the system is that a set of rules and incentives has been allowed to develop by the brokers, exchanges and regulators that both permits and encourages predatory trading behaviour by HFTs.

Canada appears to be a bit further ahead in curbing predatory HFT than is the case in the United States and some other jurisdictions. In 2012, IIROC implemented tougher rules on HFT within dark pools in Canada. Since then, HFT firms share of Canadian equity trading has shrunk. With the publication of Flash Boys, pressure on brokers, exchanges and regulators to level the playing field for investors will likely increase. That would be good for investor confidence in the stock market.   

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