I have been reading the new book “Flash Boys” by Michael Lewis, which concerns high frequency trading (“HFT”) and automated electronic trading systems. The book has garnered a lot of attention, primarily due to its allegation that the markets are “rigged”. Indeed, the book presents compelling evidence that very sophisticated computer driven systems, which make trades thousands of times faster than any human, have changed the nature of investing. But only for some, and not for all.
There are three kinds of players in the stock market. The first, and in our view, most important, are investors. They seek to buy a part (usually a very small part) of a company in the expectation that they will hold their shares and benefit from the company’s success by way of dividends and an increase over time in the value of the stock. Investors have a time horizon measured at a minimum in months, and for successful ones, in years. For smaller investors, high frequency trading is to some extent a benefit, as it results in more trading, more liquidity in the market, and the ability to buy and sell easily. A very small incremental cost might be paid on some large trades due to HFT activity but this amounts to perhaps a few hundredths of one percent per year. Large institutional investors, who buy and sell stocks in chunks of hundreds of thousands of shares are the real targets of the electronic trading schemes. By “front running” or seeing the orders of these institutions before they are executed, the electronic traders can make a penny here and a penny there per share on these large trades. It is profit for them and cost to the clients of the institutions. While the cost to any individual is small, the total “take” from these activities is in the hundreds of millions of dollars annually.
The second kind of market participants are the speculators. Day traders and buyers of penny mining stocks, technology start-ups and drug companies with no approved products usually fall in to this category. Their interest is not in the success or failure of the company; they are motivated by short term market gains as other speculators buy into the latest hot stock. Speculators usually expect to hold stocks for hours or days, but certainly not for weeks much less months. For speculators, HFT is a positive boon. It ensures that there is enough daily activity to allow them to move in and out of stocks easily. For speculators, trading costs are mostly irrelevant; they are in the game for the big score.
Finally, there are the new players, the high frequency traders themselves. They operate in the shadows of the markets, seeking technological advantages which allow them to game the system. The programs used by these trades operate inconceivably quickly; trade execution times are measured in thousandths of seconds, far faster than the blink of an eye. High frequency and electronic traders have no interest whatsoever in the proper functioning of capital markets, in the fortunes of companies or the economy. They do not exist to invest and their average hold time is much less than one second. They are purely predatory in nature; they feed off the other participants in the market.
Few argue that what the HFT and electronic traders do is illegal. At the same time, many argue that the net cost to all others, particularly institutional investors, is significant enough to require changes to the rules. Those who find the subject interesting should read the Lewis book and make up their own minds. We view the subject as fascinating but largely irrelevant to our activities. The costs to our clients are miniscule and in the long run, which is where we are focused, of no consequence at all.