High-Frequency Traders: Part 2

Netted by a Salmon
Last week's column on high-frequency traders (HFTs) was inspired by Michael Lewis' new book, Flash Boys. In the book, as well as a provocative 60 Minutes interview, Lewis maintained that the stock market was "rigged" against the small investor. This claim caused much concern among Morningstar.com readers.

The charge, it turned out, is bogus. My column fired an early salvo, but Lewis' full defeat came a few days later courtesy of Felix Salmon's Slate book review, The Lewis Effect. Highlights:

"By creating an oppositional narrative of what he explicitly describes as "good guys and bad guys," Lewis runs the risk of turning a highly complex issue into an unhelpfully simplistic morality tale."

"The problem with Flash Boys is that the demands that master storyteller Michael Lewis makes of his narrative don't align well with the structural problems of HFT that Lewis the journalist should want to expose. The result is that the general public, after reading this book or watching Lewis on 60 Minutes, thinks that the scandal of HFT is that they're being ripped off, and that the stock market is a scam. Neither of which is true."

"If your mom has a brokerage account, or a mutual fund manager, or generally entrusts her retirement savings to any kind of intermediary, then the fees charged by her broker or fund manager will dwarf any profits being skimmed from her by HFT. And if your pop invests in the market himself--if he's among those people with a TD Ameritrade or E-Trade or Schwab account, the "easy kill" for the high-frequency algorithms, then, in reality, he is the one big winner of the high-frequency game."

"What we're seeing, in the world of HFT, is not fraud, nor is it insider trading. Rather, HFT is a ridiculously and unnecessarily complicated mechanism for divvying up intermediation revenues between banks, exchanges, high-tech communications outfits, and various algo-driven shops. Everybody is in on the game: not just the HFT guys, but also the exchanges, which optimize themselves for HFT game-playing, and the banks, which let HFTs into their dark pools, and especially the SEC, which has been cheering on the whole motley crew from the beginning."

More Smoke Than Fire
Michael Lewis has a story to pitch. So, too, do the heroes of his tale, the brokerage firm IEX and hedge funds, which have trades to generate and profits to reap. They benefit, handsomely indeed, by standing beside the little guy in the fight for truth, justice, and the good old American way of taking care of the small investor--which, of course, never did exist. Retail investors now get better deals on execution, brokerage commissions, and fund fees than ever before. The reign of HFTs coincides with the reign of the everyday investor.

"Coincides" being the operative verb. Although HFTs have helped to lower trading spreads and provide market liquidity, these effects aren't large for buy-and-hold investors. The improvement in their fortunes has come from elsewhere: the development of index funds and exchange-traded funds; the growth of discount and Internet brokers; and technological improvements that permit more-efficient stock trading.

HFTs don't meaningfully improve the typical investor's results. But they don't get in the way, either.

Two Problems
There are real concerns about HFTs. One is their potential for inadvertent mischief. Although it has been four years since the Flash Crash, when the Dow Jones Industrial Average dropped 600 points in five minutes because of order imbalances caused (primarily) by HFTs, the relative calm does not mean that the danger has been resolved. The ability of HFTs to cause market earthquakes remains unclear. Nobody--not the exchanges, not institutional investors, not the HFTs themselves--understands when and how HFTs can become dangerously destabilizing. The existence of HFTs menaces the stock market's dependability.

Also, many HFTs may operate illegally. I am no better positioned to comment on investment law than I am on astrophysics, but Mercer Bullard of the Mississippi School of Law and the founder of Fund Democracy, most certainly is. Bullard points out that some (although not all, apparently) HFTs purchase detailed, up-to-the-millisecond trade information from exchanges--data that are essential for those HFTs' algorithms. The stock exchange pockets millions for selling the data feeds, the HFTs have an advantage on other parties, and the rest of us are on the outside.

Bullard rejects the defense that this does not constitute insider trading because anybody may write a seven-figure check to purchase that data. Writes Bullard, "Advance access renders the terms on which everyone else receives the NBBO data unfair, unreasonable, and unreasonably discriminatory. In the words of one academic, 'The exchanges benefit from essentially selling the same data twice, albeit at different speeds.' " Bullard adds that these HFTs appear to be escaping prosecution because "the exchanges have a vicelike grip on the data" that are required to bring a successful case.

In short, while HFTs undeniably bring small ongoing market benefits, as discussed by Morningstar's Sam Lee last week, they also increase the possibility of a catastrophic event. To use the old adage about those who seek profits by selling options, permitting HFTs to exist may be a case of picking up nickels, until one day being run over by a steamroller. Also, even if the net effect of HFTs is positive, writes Bullard, that "does not cleanse everything they do."

That HFTs are not guilty of the crimes charged by Lewis does not make them innocent.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.