Traders have always had a need for speed. The classic example is 19th-century London financier Nathan Rothschild, who learned of Napoleon’s defeat at Waterloo a day ahead of the official reports.
Some versions of the legend say Rothschild got the news by carrier pigeon; others say he employed couriers on horseback. Either way, his information network was a forerunner of the computer networks built by today’s high-frequency traders. The difference is that while Rothschild sought an advantage in information that would move the market, modern speed demons seek information about the market itself.
“Flash Boys,” a new book by Michael Lewis, has put a spotlight on high-frequency trading, but professional investors have long been aware that predatory computer networks were watching their orders.
High-frequency traders capitalize on the milliseconds needed for information to travel between various stock exchanges. They learn when, say, a mutual fund places a big buy order, and they scramble to insert their own orders ahead of it.
That can cost the mutual fund a penny or so on each share it’s trying to trade, with the high-frequency trader pocketing that penny as profit. Many investors resent this sort of front-running.
“When I enter an order to buy or sell a stock, the information contained in my order is my property and my property alone,” says Norm Conley, chief investment officer at JAG Advisors in Ladue. “Why should a firm be able to step in between me and my order initiation and thereby influence, even by a very small slice, what actually occurs in my trade event?”
Conley, though, doesn’t lose any sleep over the extra trading costs he may be incurring, and he disagrees with Lewis’ contention that the market is rigged.
The high-frequency traders, after all, aren’t pure villains. They bring liquidity to the market, which narrows bid-ask spreads and makes it easier to complete a trade. That’s good for all investors.
So, can we keep the benefits without putting slower investors at an unfair disadvantage? That should be the overriding goal.
Lewis’ book actually offers some hope in this regard. The heroes of “Flash Boys” are whizzes who have found a way to temporarily hide orders from the high-frequency crowd. They’re fighting algorithm with algorithm.
Academic research suggests that regulators also may be able to level the playing field without hurting liquidity. Mao Ye, an assistant professor of finance at the University of Illinois, suggests that if stock prices were quoted in increments of less than a penny, much of the high-frequency advantage might be competed away.
The current 1-cent “tick size” acts as a price constraint, especially on low-priced stocks, “so there’s an oversupply of liquidity at the constrained price,” Ye says. “Speed is how you break the tie. If I am faster than you, I jump ahead of you.”
Bidisha Chakrabarty, an associate professor of finance at St. Louis University, studied the response to a 2011 Securities and Exchange Commission rule that tightened compliance procedures for some high-frequency traders.
“The number of quotes sent to the market dropped by one-third after this rule went into effect,” she says. “Liquidity didn’t become worse, and in fact most measures of liquidity became better after these hedge funds were restricted.”
Regulators shouldn’t try to outlaw high-frequency trading; these speed-loving heirs of Rothschild bring benefits as well as costs. Those of us who can’t think in nanoseconds, however, need assurances that the market is fair for us too.