A lot has been made about high-frequency trading lately. Particularly in light of the 60 Minutes interview with author Michael Lewis about his new book, Flash Boys: A Wall Street Revolt, which aired at the end of March.
In the interview, Lewis is quoted as saying “stock market’s rigged” and that the victims include “everybody who has an investment in the stock market.”
For those of you who may not be familiar with the term, high-frequency trading is a type of electronic trading that makes use of extremely powerful computers and trading algorithms in order to transact orders at the fastest execution speeds possible.
Unfortunately, I think there is a severe misunderstanding of what high-frequency trading really is and how it affects markets and investors.
I am concerned that the national conversation will become dominated by the negative headlines and will ignore the significant benefits that high-frequency trading provides.
Shocking Headlines Sell More Books
While I am generally a huge fan of Michael Lewis (my favorites include Liars Poker, Moneyball, and The Big Short), in this case I believe he is spinning the story to sell a new book.
Lewis has essentially taken the stance of “sounding the alarm” that the stock market is rigged and I think his message caters well to the audience who might buy his book.
The reality is that high-frequency trading is more or less a natural extension of electronic trading, which itself was an obvious improvement over floor and phone trading.
High-frequency trading strategies have been in place for at least the last 15 years and have accounted for a significant and growing volume of trading activity.
Concerns about High-Frequency Trading
Are there problems with high-frequency trading? Yes. Probably the single most talked about is a strategy known as front-running.
Front-running is a practice where a trader (using high-frequency trading) will identify a buyer’s order before it is executed, buy the security ahead of the buyer, and then turn around and sell it to that buyer at a higher price (all within milliseconds).
However, most experts believe that front-running represents a small minority of high-frequency trading. In addition, it is likely to have little impact on individual investors.
Benefits of High-Frequency Trading
More importantly, the benefits of high-frequency trading appear to significantly outweigh the downsides. For example, there is strong evidence that high-frequency trading has:
- Lowered bid-ask spreads, thereby improving liquidity for all participants
- Reduced transaction costs by a substantial margin (Vanguard estimates that there transaction costs have been cut by 60% in the last 15 years, resulting in hundreds of millions of dollars in savings for their investors)
- Made the market for exchange-traded funds (ETFs) possible by ensuring the trading price of an ETF aligns with the value of its underlying assets (also known as its net asset value or NAV)
- Overall, made markets more efficient for investors
Thus, while I think much needs to be done to understand exactly how high-frequency trading is being used (and possibly abused), we shouldn’t paint a broad brush and assume that all high-frequency trading is bad for investors.
We also shouldn’t jump to bold conclusions about the stock market being rigged without knowing all the facts.
For additional reading on high-frequency trading, check out the following articles:
- Be Thankful for High-Frequency Trading by Samuel Lee (Morningstar)
- Michael Lewis’s flawed new book by Felix Salmon (Reuters)
- High Frequency Trading: All You Need To Know (Zero Hedge)
- High-Frequency Hyperbole by Cliff Asness and Michael Mendelson (The Wall Street Journal)