Last Sunday, the investigative news program 60 Minutes ran a piece on High Frequency Trading(HFT). Steve Kroft was the lead reporter. Most participants in the financial community would welcome an investigation into high frequency trading. 60 Minutes should be praised for taking it on.
However, they really didn’t delve deep enough into the issue. Their story was half baked. There was a lot of data brought out, some decent interviews with interested parties, but no substance. Hopefully, they will revisit the story and investigate much more deeply. This is truly one that deserves attention.
Many of the HFT issues are simply microeconomic issues. Anyone that has taken a microeconomic course that is taught correctly has heard about externalties, Coase theorem, monopoly, oligarchy, network effects and perfect competition. Other issues are are a part of operations management. Bottlenecks in networks, messaging, network pipes are big issues. Still others are a piece of any basic Investments class. We have the necessary frameworks to deal with HFT and its effects, but need to apply those concepts correctly.
There are a lot of misconceptions about HFT. The misconceptions come because it is a relatively new phenomena brought about by the electronic marketplace. The days of traders on floors executing orders is long gone. But, the HFT guys are replacing the old local traders that traded their own money, the specialists, and other market participants that were simply there to make a buck.
HFT guys try and make money, they just do it quicker than the human eye can blink.
Markets have always been about speed. In the old human days, the people on the floor had better access, and thus could react quicker. Those minutes meant dollars. Today, as 60 Minutes touched on, HFT firms pay to “co-locate” their servers next to exchange servers. No one can beat them. There are orders that are entered into the market that the human eye cannot comprehend fast enough, and HFT firms can jump on them before anyone else even knows they are there. That speed is worth billions.
On the show, they interviewed one HFT trader who said they never had a losing month. If you look at investment bankers, many of them rarely lose money either. Most of them have an increasing percentage of their top line revenue that comes from proprietary trading. In the recent Fin Reg Law, they tried to curb prop trading, but the banks simply reclassified those employees as “asset managers”.
As more and more HFT traders enter, the field is getting crowded. There are HFT traders in Chicago that are not making money. HFT comes with a high fixed cost, and many of them are not covering that fixed cost. Mind you, I am not advocating for anyone to have a tag day for the poor poor HFT guys, but there is more than one aspect to the story!
Electronic trading was supposed to broaden the marketplace. Instead, because of the slanted playing field the marketplace is collapsing on itself. Fewer entities trade more of the volume. The network effects are not changing, and each day they trade an ever increasing amount. What happens to the market when there are very few players making markets? The flash crash of May 6 is one symptom.
What are the real issues? At the core, this is poor government regulation in action. The Securities and Exchange Commission (SEC) is ill equipped to handle changes in the marketplace. Certainly, they were not equipped to handle the evolutionary change of electronic trade. As a matter of fact, many changes to regulation and business practice they made from 1995-2005 ruined the marketplace. The SEC has never been a “principles” based regulator. It’s not in the SEC’s DNA. They are more of a ticket writer, a patrolman. The culture of the SEC is not correct for the dynamic, evolutionary time we are in.
Let’s tick them off one by one and try and explore what they mean economically, operationally, or in investment terms.
Payment for order flow is a practice where an investment bank, or hedge fund can buy order flow from a discount broker and trade against it. For example, Citadel pays for order flow from eTrade. When the flash crash happened, Citadel refused that order flow. This practice codifies in regulatory terms the practice of banks and hedge funds ripping off the small customers that put orders through discount brokers. They trade against those orders and then risklessly arbitrage them into another marketplace.
In a twist to this, HFT firms also get paid by exchanges and dark pools for their liquidity. This acts as a subsidy. The HFT firm can employ a strategy of trading for a half cent. They will lose money on each side of that half cent trade,but make money overall since they are paid more than a half cent for the liquidity! Essentially they are taking no risk, and providing nothing but liquidity to the market. The SEC could end this with the stroke of a pen.
Internalization of order flow is another nefarious practice. Let’s say you enter an order into your expensive brokerage house. If you enter an order as a market, there is no doubt that your order will be abused by the internal prop trading desk. They will take the other side and arbitrage it back into the market-or use it to close out a position. If you enter that order as a price order, even though the stock may publicly trade through your price, you might not get filled. You’ll only get filled if the trading desk can internalize your order and make some money off of it. The SEC could end this practice with the stroke of a pen as well.
The uptick rule was suspended by the SEC in 2007. Ironically, the last time we didn’t have an uptick rule was in the stock market run up in the 1920’s. The uptick rule should be brought back. This should be done not because shorting stock is so bad, it isn’t. It should be done because the cash equity markets is the place that companies use to raise equity capital to grow their businesses. The risk profile of shorting is higher if a company has to short on an uptick. There ought to be higher risk for shorting, given what the market is responsible for. In futures markets, there is no uptick rule and shouldn’t be. They provide a different functionality to the marketplace. Bring back the uptick rule and confidence will seep back into the market. The flash crash may never have happened with an uptick rule.
Shorting of stock is a necessary part of the market. However, a company shouldn’t be able to short more stock than the float. In past years, shorting rules were skirted, and the market was short more stock than the entire company had outstanding in rare cases! With electronic markets, there should be an easy way to track stock. Establishment of a functioning single stock futures market would help as well. There was an effort to do this in the early 2000’s, but it was scuttled by the SEC and SEC regulated exchanges.
The industry has been hurt by excessive fragmentation. Dark pools of liquidity started a few years ago, and now there are over 80 of them. This makes the entire marketplace less transparent and competitive. Orders go into dark pools and the proprietor of the dark pool makes the market. They don’t have to necessarily compete with anyone else. This should be stopped, and sunlight should be shined on all dark pools. They should be subject to the same exact strictures that regulated exchanges, like the NYSE and NASDAQ are subject to. Trades with volume and price information should be reported instantaneously. If one takes a peek at how the corporate bond market, and muni bond market function, that is what the big players would like for cash equity and options markets. It’s pretty hard for anyone to believe that these dark pools can’t get their business done on established exchanges. 70 billion has been pulled out of the stock market since the flash crash in May. It’s not coming back, but being reinvested in US Treasuries and precious metals.
HFT firms themselves have engaged in poor practices designed to confuse and obfuscate the marketplace. They send a raft of request for quote messages to tie up the pipelines of exchanges and dark pools. They employ “sniffer” orders to try and set off stops, trade against or in front of big orders and generally do things that would have been illegal and punishable in the formerly all human environment. These types of actions should be eliminated. If an HFT firm is found doing them they should be fined a significant amount, or simply shut down. Programmers have to program algorithms to engage in those practices, so it’s not an honest mistake, but a strategy.
The investment strategy of various players in the market should be of no concern to anyone. There have always been short term swing traders, momentum players, and long term investors. Data that has recently come out on HFT finds that it has no real effect on long term investing strategies. But we need a lot more research and data.
The real problem is that there are a lot of sacred cows on Wall Street and in Washington DC. Those cows need to be gored. Goring them will not guarantee that the market will always move north. But, at least people on the street, managers of funds, and CFO’s of companies will think they have a fair shot of making a good decision. The Dodd-Frank Law that Obama exhorted and signed did nothing to change the climate. The cows’ thrones are still protected.
It’s very clear that the market place on the SEC side is totally dysfunctional. It’s not working. People on Main Street are getting hurt, but more importantly the CFO’s of America’s companies have lost confidence in the integrity of the marketplace. With correct regulation, the SEC can level the playing field and make the market far more competitive and efficient than it is today. Applying basic principled concepts correctly will be the cure.