In recent years, high frequency trading (HFT) has been the subject of a character-driven book, a top-rated network news segment, numerous television panel debates and stories in the opinion and news pages of some of the top-circulated business publications in the world. Lost in those formats, was the ability to develop a meticulous, long-form explanation of why HFT has been such a successful, efficient and profitable market intermediary, while phasing out traditional players who are slower and more expensive. In the absence of this information, a lot of misconceptions have gained momentum.
Peter Kovac was a computer programmer who later served as COO of the global multi-asset market-making firms EWT & Madison Tyler from 2004-2011. In those roles, he had to be intimately familiar with the operation and regulation of market structure. Peter’s book Flash Boys: Not So Fast (available at Amazon.com) was written as a detailed and direct rebuke to egregious claims made about HFT. While MMI had no role in the production of the book, we support its findings and excerpt/summarize some of the book’s passages below in a question and answer format.
Does speed disadvantage average investors?
Individual investors are, happily, insulated from the arms race to go faster and faster. It doesn’t matter whether you or I are faster or slower than the professional traders, because we are doing different things. The professionals race each other to react to new market wide information. New information is broadcast – Microsoft beat earning expectations last quarter – and the pros race to be the first to adjust their resting prices and trade Microsoft shares.
For individual investors there is no race at all. You invest because you decided that you wanted to. Nobody else in the market knows why or when you made this choice, so nobody could race you if they wanted to. When you place your market order to buy shares in Apple, it executes the instant it hits the market.The pros never even see your order coming. They only see the trade created by your order, after it has already executed and become a part of history.Speed doesn’t matter for individual investors, since there is no race to be run.
Does HFT front-run large orders?
It is more likely that Economics 101 is to blame. In the law of supply and demand, if you increase or decrease the supply, the price falls or rises to respond. This paper from University of California, Berkeley Professors Robert P. Bartlett, III and Justin McCrary, uses timestamp data from the two Securities Information Processors (SIPs) to examine SIP reporting latencies for quote and trade reports. Trading surrounding SIP-priced trades shows little evidence that fast traders initiate these liquidity-taking orders to pick-off stale quotes. These findings contradict claims that fast traders systematically exploit traders who transact at the SIP NBBO.
Are frequent price changes unfair?
Fifteen years ago, stocks were not allowed to be priced in pennies – all prices had to be rounded to the nearest fraction of a dollar. Today, stocks can be priced in penny increments. While more precise prices mean you get a better deal, it also means the prices change more often. Imagine your grocery store used to only trade in dollars: milk was $5 a gallon, eggs were $3 a dozen. These prices almost never changed.Then the grocery store starts using pennies: milk is now $4.69 a gallon, eggs are $2.89 a dozen. Next week the prices might be a nickel higher or lower. The new system means (a) prices change more frequently than previously, but (b) the more precise prices allow you to get a better deal. So it goes in the stock market. Now that prices are allowed to be more precise, they change more frequently – but the prices are more accurate and investors get a better deal.
Does HFT profit at my expense?
While there are those who believe there exists a legal and prevalent form of front-running that guarantees profits, the facts and logic don’t support it. For this scheme to be successful it is important to recognize the main elements needed to make it work. Namely, the knowledge of how much stock the front-run are trying to buy and the ability of the front-runner to turn around and sell that amount, to those being front-run, at a higher price.
How would the alleged front-runner move the market to that “higher price”? By law, nobody can trade at a higher price until every single offer in the market at the lower price is gone. The only way to get rid of somebody else’s lower offers is to buy them up. So, for this scam to work, the front-runner has to buy every single share in every single market that is offered at the current price. This premise is utterly absurd. If it were true, every time a new order for 100 shares hit the market, the front-runners would have to purchase every single share available at the current price. Within a few minutes, they would own millions of shares – and they’d have to unload them for a serious loss.In short, such a business model would be unpredictable and unprofitable.
Does a slower SIP create advantages?
It’s impossible to trade with the SIP. Trades occur when orders are matched at the same price. One doesn’t trade “with the SIP.” For those who believe a quicker trader could stick an investor with a stale price, this is simply impossible. One popular example involves Apple trading at 400.00 – 400.01, and the SIP indicates one can buy Apple at $400.01. While the “slower-footed” investor is looking at the SIP data the actual market nudges up to 400.01 – 400.02. What happens if a high-frequency trader tries to buy shares at the outdated SIP price of $400.01? Nothing. The price of the buy order, $400.01, is lower than the new offer at $400.02, and it doesn’t match it. No trade. Trades only occur when the prices of the orders match. It’s impossible for a slower trader to buy the shares at an outdated price.
Did HFT cause the “Flash Crash?”
For stock market pundits, the flash crash of May 6, 2010, when the stock market and stock futures markets plunged 6% and recovered only twenty minutes later, is something of a Rorschach test. For data-driven analysts, this was an opportunity to dive deep into the complexity of the derivatives and equities markets, evaluate how they had failed, and fix it. Another group, however, gleefully rubbed their hands together in anticipation of a witch-hunt indulging their favorite conspiracy theory: high-frequency traders gone wild. When the SEC and CFTC issued their joint analysis after five months of investigation, the former group got what it wanted, and a series of market reforms were implemented to prevent a recurrence of the event. The latter group was sorely disappointed in the conclusion – it did not blame high-frequency traders – and quickly dismissed the report out of hand.
BlackRock Viewpoint, June 2011