Flash Boys and Flashy Headlines
By now, most of you are familiar with Michael Lewis’s new book, “Flash Boys” and the whole high-frequency trading (HFT) phenomenon he’s focused on. Lewis has been making the rounds starting with a segment on 60 Minutes a week ago Sunday, followed by the Today Show, the Daily Show, and pretty much any media outlet that will have him. An extended excerpt was also published in the New York Times Sunday Magazine (“Wolf Hunters of Wall Street”). Lewis’s thesis, for those of you who aren’t familiar with the story, is that smart technologists have figured out ways to legally “front run” other investors, driving up their cost of buying shares.
Of course, it was pure sensationalism for Lewis to insist that “the stock market is rigged,” as he did during his 60 Minutes appearance. HFT has been around for some time now and has been monitored and studied by institutional investors and academics alike. A recent academic study that examined the impact of HFT by focusing on Apple shares found that the median impact on the price per share was something like a penny. Which is a lot of money if you can repeat the process millions of times, to be sure, but not something most investors would notice.
In any case, all of Yeske Buie’s stock exchange trades are essentially handled by Dimensional Fund Advisors (DFA) and Vanguard and they do a pretty good job of monitoring and controlling the “market impact” of their trades including any HFT traders who try to front-run or piggy back on their buying and selling activities. Joe Brenan, global head of Vanguard’s equity investment group, has recently pointed out that, while high-frequency traders may sometimes “push things too far,” they have in general increased liquidity and integration across multiple markets in a way that has lowered trading costs. As for DFA, a lot of the trading the company does is “off market” altogether and doesn’t even go through an exchange. For certain kinds of stocks, they’re one of the largest “block traders” in the market. For example, if some institution owns a big chunk of a thinly-traded stock that they’d like to sell, rather than dump it on the market where it will drive the price down, they’ll call DFA’s trading desk and negotiate a price that is lower than the current market price, but higher than what they could get if they just dumped their shares and drove the price down. So DFA is able to obtain the stock for less than its current trading price. I guess you could say that our clients have some pretty sophisticated institutional traders of their own when it comes to earning extra returns through smarter trading.
This all puts me in mind of the “old days” (the mid-eighties) when I worked on the options trading floor of the Pacific Stock Exchange (PSE). Then, you had options “market makers” in the “pit” filling buy and sell orders from institutional and retail brokers. It could be quite lively as the exchange used an “open outcry” trading system in which the market makers would call out their best bid and offer for any option that a broker indicated he was trading. The broker would then decide who had been first with the highest bid or lowest offer, depending on whether he was a buyer or seller. As a market maker, you didn’t want to get on the bad side of any broker as that person would mysteriously become deaf to the sound of your voice and your trading opportunities would thus be diminished. On the PSE stock trading floor next door, meanwhile, you had a “specialist” system in which one person was charged with maintaining an “orderly market” in each stock that was listed on the exchange. The specialists maintained a “book” of orders for each stock that they would fill as prices moved up and down, at the same time buying and selling for their own account. These were systems that worked, on average, but where lots of things could get tilted one way or another for a variety of human and financial reasons.
During my tenure on the floor, we also started trading options on NASDAQ-listed stocks. These were generally the stocks of smaller companies (1-800-Flowers.com is a current listing) but also included a few giants like Apple Computer. NASDAQ today is a 100% electronic stock exchange but back in the 1980s it was a collection of “dealers” who would “maintain a market” in the exchange’s listed securities by offering to buy or sell shares of each stock they followed. This was a dispersed network of people working from behind their desks and trading was effected by calling one of the dealers on the phone and asking for a quote. Just as Lewis’s hero, Brad Katsuyama, found when placing his electronic trades, it seemed like every time someone actually tried to buy anything approaching the quantities quoted, the dealers would “fade,” saying that there weren’t as many shares available at the previously quoted price and the buyer would have to pay a higher price to complete the full order. This was tremendously frustrating to the options market makers since the complex options strategies they assembled depended on their ability to buy or sell shares at the quoted price. Plus ca change, plus c’est la meme chose!
The same stocks were often “cross-listed” and traded on regional exchanges like the Pacific and Philadelphia Stock Exchanges as well as on the big exchanges in New York: the NYSE and the American Stock Exchange. Sometimes an alert trader would notice that shares of a particular stock were being offered more cheaply on one exchange than on another. If fast enough, the trader could buy shares on one exchange and sell them on another, pocketing the spread. This is called “arbitrage” and it’s a process that has existed for as long as markets. It’s a natural activity that helps keep all markets and prices aligned, since the selling activity in one market will drive the price down just as the buying activity in the other market drives it up until the prices on the two exchanges converge. That Lewis should call arbitrage a “predatory practice,” as he did, has as much to do with sensationalizing his topic as anything else.
At bottom, the story he tells is as simple as this: some people figured out a way to get trading information faster and to create an arbitrage opportunity; then some other people figured out what the first group was doing and developed a system to remove that arbitrage opportunity. This is about as new as an ancient Phoenician buying grain cheaply in Egypt and selling it dear in Jerusalem and pocketing the difference. Go figure.
On an historical note, some of the Kevin Bacon film Quicksilver was shot on the options trading floor while I was there and I was hired as an extra. I can be glimpsed briefly in floor trading scenes at the beginning and (especially) at the end of the movie.
In writing all of the foregoing, I’m aware of the risk of being branded an “apologist” for market manipulators. That is not my intent. At Yeske Buie, we are not part of the Wall Street establishment and have nothing to gain from those who try to profit from sharp trading practices. To the degree that any market participants are gaming the system and creating an unlevel playing field, we believe that better regulation should be brought to bear. As a general proposition, markets work and are the best way to assign prices to securities like stocks and bonds. However, for markets to work well, certain conditions must be met, including the requirement that all participants have access to the same information (i.e. that there by no “asymmetry of information”) and anything that artificially interferes with that should be regulated away, wherever possible. This kind of asymmetry of information was one of the things that caused the market meltdown of 2008/2009 when companies like AIG were writing Credit Default Swaps (CDOs) outside of any public market environment, leaving financial institutions and other investors in the dark as to the size and magnitude of the financial obligations that had been created. Banks and insurance companies had successfully lobbied Congress to have these instruments excluded from the oversight of regulatory authorities because transparency was bad for their profit-margins (and, it turned out, bad for the economy!).
As for the “dark pools” that Lewis writes about, in which Wall Street firms fill customer orders from their own inventory with little or no disclosure or give HFT firms first shot at customer trade flow, there is much to say. I served as president of the Financial Planning Association (FPA) in 2003 when the SEC was provisionally allowing Wall Street firms to offer fee-based advisory services without requiring them to act as fiduciaries, which would involve putting their clients’ interest first as do other fee-based advisors who operate under SEC scrutiny. This left such firms free to engage in practices like filling customer orders from the firm’s in-house inventory without disclosing the profits they made from those trades, all the while pretending to be compensated solely by the explicit management fees they charged. The Financial Planning Association sued the SEC over this dispensation, commonly referred to as the “Merrill Lynch Rule,” and we ultimately won. A David and Goliath win for the average investor, to be sure. However, even though this victory prevented the Wall Street firms from masquerading as fiduciary advisors, it didn’t stop them from continuing the abusive practices.
In the end, I suppose my point is simple: if the market is rigged, it has always been thus. Efforts by government regulators and self-interested institutional investors to reduce or eliminate opportunities to game the system are an ongoing imperative. Eternal vigilance is required since new technologies will always create new opportunities to profitably take advantage of your fellow investors. Through all of this, however, anyone who failed to invest because they believed that floor traders, market makers, specialists, or dealers were in a position to game the system, ended up far worse off than those who took their chances on an imperfect market and put their capital to work. At the end of the day, the market may not be perfect but it is not “rigged.”
Postscript: Three weeks after we wrote this piece, Laurence B. Siegel published an interesting piece on the Advisor Perspectives website (Tempest in a Teapot: Michael Lewis’ Flash Boys Solves a Problem that is Barely There). Larry is the Gary P. Brinson Director of Research at the Research Foundation of CFA Institute. The entire piece is worth reading but we find ourselves in agreement with one of his conclusions:
If HFT revenues are a tax, then (before counting any benefits they produce) they do some harm. One must then ask whether the benefits outpace those costs, and by how much. This is not a moral question but an empirical question for which we do not yet have an answer. The answer is in data yet to be collected and studied.
And the data have changed because of the activities of Brad Katsuyama. The battle to rein in the costs imposed by HFT may have already been won.
It would indeed be interesting if it turned out that the forces of free enterprise, in the form of Brad Katsuyama’s IEX exchange, had done away with the problem before Lewis’ book had even hit the shelves.