Michael Lewis’s “Flash Boys” purports to reveal a system of “market-rigging” by the intervention of high frequency traders into executions of market orders. Using some of the same sources that he used to source his highly misleading book “The Big Short,” he created a “sky is falling” atmosphere by promoting his book as the revelation of rigging the market. He portrays a supposed fraud on ordinary traders by high frequency traders because of their ability to step in front of a trade and execute it for themselves at that price and then resell to the trader with a miniscule mark-up, thereby gaining huge profits when these miniscule mark-ups are repeated millions of times.
This has been labeled “insider trading” by many uninformed people, but it almost surely is not, because the high frequency traders do not appear to possess material non-public information when they trade. I have not yet seen evidence suggesting they were engaged in committing any form of fraud, or breaching any fiduciary or fiduciary-like duty of confidentiality through the process by which they gain access to trade order information before it gets from the exchanges to market-makers responsible for trade execution. They certainly do not have material non-public information about the public company whose stock is being traded, which is the standard fare of insider trading violations.
Whether this is a form of “front-running” is another issue. Front-running is a description of trading that occurs when someone learns about an impending trade order, knows that this order will “move the market price,” and steps in front of the order to make a trade before the order hits the market (and moves the price), then usually pockets the profit by selling at the new market price. This typically would be seen only when people have access to confidential order information involving large block orders of a stock that could conceivably move the market price enough to allow for a front-running profit after costs of order execution are taken into account. What Lewis describes as high frequency trades are not this type of front-running because they do not involve large block, market-moving, trades. And it is not at all clear, as compared to front-runners who misuse confidential access to trading information for their own benefit, whether the high frequency traders are engaging in an impropriety at all, since, once again, there is no apparent source of a duty of confidentiality they would be breaching.
Finally, the “market rigging” aspect of HFT would seem to be a hyperbolic, publicity-grabbing description, at best. The focus appears to be on cumulative profits allegedly gained by the high frequency traders, but the actual impact on specific trades is so small as to be immaterial to the person who entered the order. How many of us, or even institutional traders, care very much whether our trade is executed at $1 per share or $1.001 per share? To be sure, the SEC should be making efforts to try to assure best execution of trade orders, but the real question to ask is what costs we are willing to incur to prevent that $.001 mark-up from occurring? In some instances, analysts appear to be showing that there could be an issue of phantom liquidity that may be worth pursuing, not because it is a fraud, but because it may be allowing incorrect liquidity expectations to impact market executions. I’ve included one interesting such analysis in the “securities markets” links to right (Nanex.net analysis of HFT trade cancellations), which appears to show that HFT sometimes results in unreliable reports by exchanges of trade offers because of high frequency traders cancelling offers before executions can occur. Whether spending, and causing others to spend, hundreds of millions of dollars or more to address such an issue in investigations and “settlements” of enforcement actions addressing what appear to be lawful practices may make little sense. Moreover, if this is an issue, it would appear to be a regulatory one, not an enforcement one, and the SEC’s experts on market practices, not the enforcement division, should lead the way. The politically-oriented state Attorneys-General with no market expertise and no authority to regulate markets should be excluded from the process altogether.
The main problem here is a common one that people like Michael Lewis, many commentators, and, unfortunately often the SEC itself, get in a huff when financial market participants find even lawful ways to make a lot of money. They seem to forget that the entire market process is, and must be, driven by the ability to garner lawful profits from trading, because that is what creates market efficiency, which is the driver of the market system. The huge ruckus created by “The Big Short” was just such a mistake. The fact that some people made a lot of money by betting on the housing market to decline, and huge institutions lost a lot of money by failing to protect themselves against a massive decline in housing values, is what markets are all about. The short trades Lewis described typically were not unlawful (the contrary verdict in the Fab Tourre case was, in my view, a travesty, because it is plain that the counter-party was not defrauded in any meaningful respect). They were either very good bets based on informed judgments about over-exuberance in housing markets, or, in many cases, very good luck when short positions put on as a hedge became wildly, and unexpectedly, profitable. The SEC wasted millions of taxpayer dollars investigating these matters for more than five years, and caused billions of dollars of expenses and “settlements” for no good reason other than to punish financial institutions for allowing a marketplace driven by huge, well-informed, institutional investors to function as intended.
Whether the same is true for the now-blossoming HFT investigations will remain to be seen, but the hype and hyperbole attendant to the investigations and commentating on this issue suggests we are moving down a similar path.
July 20, 2014
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