Following the FBI’s announcement of a wide-ranging probe into high-frequency trading (HFT), the Securities and Exchange Commission (SEC) has placed its focus on the same area. “We currently have … a number of ongoing investigations regarding various market integrity and structure issuers, including high-frequency traders and automated trading,” said SEC Chair Mary Jo White, when testifying before a House of Representatives Appropriations subcommittee. Best-selling author Michael Lewis’s new book, “Flash Boys: A Wall Street Revolt” further fueled the long-standing debate that a group of tech-savvy insiders rigged the stock market using HFT.
What is High-Frequency Trading? Put simply, HFT is the computer algorithms used by sophisticated institutional investors to arbitrage away the most diminutive price discrepancies that only exist over the most minute time horizons—meaning a fraction of a penny within a millisecond. Eric Budish and John Shim uses the 2011 data in their new paper to show how the price difference between exchange-traded funds tracking the S&P 500 index perfectly correlated at minute intervals, while the correlation disappeared at 250 millisecond intervals. Therefore, investors could make a bundle in exploiting this “inefficiency.”
This development seems benign at the outset. The trend of squeezing the bid-ask-spreads (the difference between what buyers want to pay and sellers want to be paid) began in 2001 when the SEC required all U.S. exchanges to convert trading from fractions to decimals and the spreads have fallen dramatically since then. For example, the minimum spread prior to the change was 1/16th or $0.0625 cents. Converting to pennies, the minimum spread became $0.01 cent, which benefited the potential investors, substantially reducing the spreads that a trader could take for crossing a buy with a sale. In other words, HFT—making up over 50% of all trading in the New York stock market according to Lewis—is providing remarkable liquidity as well as price advantages to the market. In addition, when an item trades in enormous quantities and velocity, competition for the transaction will squeeze margins.
You probably think this is merely the next development in response to investors’ ever-increasing appetite for lower costs and speed. However, that may not be the entire story. According to Lewis, the average operation of the HFT market is somehow taking money from the small investors and handing it over to the plutocrats, instead of the other way around. The programmed algorithms allow the “front-running” of stock exchanges, allowing the big Wall Street banks and hedge funds to bag billions every year with the practice. The traders, with knowledge of investors’ intention to buy stock, can execute a purchase just ahead of their order. This lifts up the price a little bit and allows them to pocket the difference. A similar manipulative device is “phantom orders,” referring to the bids of high-frequency traders with no intention to accept but to test the market price. Normally, these “phantom orders” are regulated as market manipulation and insider trading.
In economics, there are certain activities that produce wealth for parties undertaking the activity but none for social wealth (increasing the size of the slice of pie); while there are certain activities that accomplish the opposite (increasing the size of the pie). In the instant case, HFT is likely to do both and the net effect—whether an investor’s slice is bigger or smaller—remains uncertain. The SEC, in response, is trying to replace gut-instinct with statistical analysis. In the last year, the SEC began subscribing to the same proprietary data trading feeds used in HFT, hoping to better understand how the markets are functioning. It remains unclear, according to White, whether the SEC will carry out new rules to police the markets.