By using the emotive phrase “rigging the market” to describe the impact of high frequency trading on the stock markets, the author Michael Lewis has guaranteed himself both extensive publicity and enhanced sales for his new book Flash Boys. In addition, by casting his story in Manichean terms as a tale of one heroic outsider taking on the evil big boys of Wall Street, he risks courting the accusation that he is special pleading for one vested interest rather than taking a principled stand against wrongdoing in the interests of a more general truth.
Yet on both counts it seems to me that he has had by far the better of the controversy that has followed the publication of his latest offering. On Wednesday last week, by chance or otherwise, he found some powerful support for his arguments from a distinguished source, the Nobel prize- winning economist Joseph Stiglitz. In a speech at a gathering of the Atlanta Federal Reserve, the latter effectively skewered any hope that defenders of high frequency trading might have had that they could defend their behaviour by invoking the moral high ground that their actions have engendered greater market efficiency in the shape of enhanced liquidity and keener prices.
It was, the professor observed, calling in aid thirty years of research into the impact of innovation on financial markets, far from clear that the arrival of high frequency trading could claim to have generated positive social welfare. Yes, it may have reduced the speed of trading, and yes it may have increased trading volumes, but there is nothing in either theory or logic to say that either consequence adds to the overall benefit of society. Indeed, the opposite may well be the case, both for the narrow community of professional investors and the wider community of participants in the real economy whose interests the financial markets are ostensibly exist to serve.
That seems a more than plausible conclusion, albeit one that has still to be formally tested, let alone proven beyond either civil or criminal burdens of proof. The key point about high frequency trading is that its development follows a familiar pattern, in which a potent combination of deregulation, technological advance and profit-seeking innovation by hard-nosed capitalists produces a game-changing new order of battle in an established area of market activity.
There will inevitably be winners and losers in any such struggle. In the case of high frequency trading, the principal beneficiaries have been the high frequency trading firms themselves, which have reaped consistent and reliable profits by taking risk to embrace and then exploit the opportunities created by the new technology. The secondary beneficiaries have been (a) the new plethora of exchanges which have sprung into life since Regulation NMS in 2007 allowed competing exchanges to become profit-seeking entities and (b) the big broking firms which have been able to make money both by establishing their own “dark pools” and selling the execution of their customers’ order flows to third parties.
The argument that Mr Lewis advances is that high frequency traders have profited particularly from the ability to use the edge that their quicker access to order flow information gives them to “front run” the orders of other investors, something that in other guises has long been illegal. He highlights the fact that a number of high frequency traders have had virtually no losing trading days for more than five years, a phenomenon that flies in the face of the common sense observation that trading is – or should be – a zero sum game.
Such a record implies, at best, that the high-speed traders are taking no risk, and at worst that they are exploiting an edge at other market participants’ expense – playing the markets, in the author’s telling phrase, the same way that card counters in a casino play blackjack. They play “only when they had an edge”. Meanwhile stock exchanges and broking firms, he alleges, have for some time effectively been complicit in this nefarious activity, often effectively at their clients’ expense.
If he is right, the argument that by reducing transaction costs and improving market liquidity high frequency trading is working to the overall benefit of investors looks weak. Prof Stiglitz argues convincingly, from evidence as well as first principles, that the ability to trade fractions of a millisecond faster than before is unlikely to be an advance that of itself has any real social value, net of the costs (in terms of heighted intraday volatility, loss of pricing transparency and other consequences) that come with it.
Most telling of all, I fear, is the fact that several of the participants in the high frequency trading game have form. We might not have believed before, for example, that the big broking firms were capable of skimming profits from their own customers, but since the inquest into the global financial crisis we now know better. The Libor and forex scandals provide prima facie evidence that opportunities to rig a market in the world of finance, if offered, will be taken. Wall Street’s moral compass, if not an out-and-out oxymoron, has patently gone awry in recent years.
In the interests of natural justice, the protagonists of high frequency trading should clearly have a chance to defend themselves against the assorted crimes and misdemeanours of which they have been accused. Maybe they have been horribly traduced and we are all too dumb to understand what in reality they do – in which case they have nothing to fear from a detailed forensic examination of their trading practices. But that there is a case to answer does not seem to this observer to be in doubt.