Michael Lewis’ new book “Flash Boys” has a lot of people freaked out about high-frequency trading. It actually has some people convinced that the stock market is somehow rigged in an unfavorable way for investors.
However, this is terribly confusing for most investors who appreciate the fact that trading commissions have never been lower, market liquidity has never been better, bid-ask spreads have never been tighter, and stock prices have never been higher.
Cliff Asness of AQR Capital Management is one of the smartest and most articulate hedge fund managers on Wall Street. In a new op-ed for the Wall Street Journal, he writes that he believes high-frequency trading has contributed to what makes the markets great for most investors:
How do we feel about high-frequency trading? We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars. We can’t be 100% sure. Maybe something other than HFT is responsible for the reduction in costs we’ve seen since HFT has risen to prominence, like maybe even our own efforts to improve. But we devote a lot of effort to understanding our trading costs, and our opinion, derived through quantitative and qualitative analysis, is that on the whole high-frequency traders have lowered costs.
Much of what HFTs do is “make markets” — that is, be willing to buy or sell stock anytime for the cost of a fraction of the bid-offer spread. They make money selling at the offer and buying at the bid more often than they have to do it the other way around. That is, they do it the same way that market makers have done it since they were making markets in Pompeii before Mount Vesuvius halted trading one day. High-frequency traders tend to do it best because their computers are much cheaper than expensive Wall Street traders, and competition forces them to pass most of the savings on to us investors. That also explains why many old-school Wall Street traders hate them.
Indeed, the folks losing business to the high-frequency traders are surely upset. But this largely bypasses and mostly benefits most investors.
So, why are we even having this conversation? Here’s Asness:
…Again, look to interests. Making mountains out of molehills sells more books than a study of molehills. But some traditional asset managers are also HFT critics. These managers are institutional investors like us but with different investment strategies and trading methods.
Rather than embracing electronic markets, these managers have stuck with their old methods. They think HFT costs them money. Often when they try to trade large orders quickly, they find the trades more difficult to execute in a market that has gravitated toward more frequent trades in smaller sizes, and that the price moves away from them faster now.
So, it’s largely a class of professional money managers and anyone benefiting from sales of “Flash Boys” who want people to get angry about all of this.
“The biggest concern we have with modern markets is their complexity and the associated operational risks,” wrote Asness. “The market structure that enables the HFTs and provides us with their benefits may also be one that risks technological calamity.”
Unfortunately, a smart discussion about operational risks doesn’t sell books quite like going on “60 Minutes” and telling mum-and-pop that their stock market is rigged.
Asness’ full op-ed is a must-read for anyone interested in the topic. Read it at WSJ.com.