Ignore all of the uproar over high-frequency trading
Individual investors benefit from tech-boosted systemApril 24th, 2014
By the time this piece is published, it shall have been about a month since Michael Lewis went on 60 Minutes to flog his latest Wall Street-oriented book. This one is called “Flash Boys.” The boys, in this case, are those who oversee and administer the high-frequency trading (HFT) component of the business.
Mr. Lewis caused a huge bunch of focus to be placed on his book when he stated on air that, “Wall Street is rigged.” That bothered me greatly as I was sure that such a phrase would be flying across the headlines—it was. I was also concerned that many investors would become all that more certain that they have been taken advantage of by this so-called rigged system—and some were.
My mission here is to help you to cut through the noise and help you better understand what this HFT is. In addition, I want to dispel any feelings you may have that you’re in a rigged scam when you invest. You’re not.
Back in the old days
We’re talking about “all the way back” to about 2005 for the basis of this HFT. The Securities and Exchange Commission passed Regulation NMS in that year and implemented it in 2007. For many years before this, stock trades in the U.S. were almost all done exclusively on either the New York Stock Exchange or on the Nasdaq.
In addition to commissions, the specialists on the New York Stock Exchange and the dealers on the Nasdaq, as a matter of normal business, had eighths to quarters of a dollar spreads to count on for each trade—times however many shares were involved. Pretty sweet deals. No one complained about “rigging”—it was just how trades got done.
One part of the SEC’s plan was to level the proverbial playing field by means of fairer trade executions and equal access to the very best price quotations. Another part was to move to primarily electronic trading. This would eliminate those slow and expensive humans that had been doing all the trading before then.
A major result of the regulation is that we now have multiple exchanges. We also have stocks being traded with the cents part of the trade going out to as many as four decimal place valuations. That’s a whole lot less than those easy eighths and quarters and, on top of it all, the trade doesn’t have to come to one place to be filled.
As you can imagine, those of the old school haven’t been thrilled with this evolution.
Speed is money
In the 1840s, the man who started the Reuters news service made a bunch of money by using fast carrier pigeons instead of the much slower trains to help dispense his information. And now, with computers, and trading models based on algorithms, your orders are processed through what’s called NBBO—the national best bid/offer. It simply reflects the fact that there’s always a small gap between the highest price that someone is willing to buy and the lowest price that someone is willing to sell. In today’s HFT world, orders are completed just about the time you’re lifting your finger from the send key.
There’ve always been middlemen in almost any business whose goal it is to profit when buyers and sellers meet. Investors of all sizes will continue to look to execute trades at the best prices (lowest possible purchase and highest possible sales price), while the middlemen traders will persist with their ambition to exploit the spread (generate profits between the bid and ask prices).
Trader or investor?
Since the vast majority of us are longer-term investors, the speed with which individual trades are done is really more a matter of interest than importance.
The high-frequency traders do make money from investors, but they do so just by being on the right side of the trade. If an HFT firm simply fills every single investor order at the best price in the market, then over the course of a day, and certainly over the course of a year, it’ll make a decent profit.
I think it’s also important to understand that there’s always going to be a “round-trip cost” to buying stock and then selling it later. Competition for public (as opposed to the big institutional money) orders and a huge investment in technology have really brought investor costs way down. It wasn’t so very long ago that $40 would’ve been a huge bargain for such a trade. Since the advent of HFT, you can do so for only about $8.
And, to reinforce the fact that HFT hasn’t added to costs, the Vanguard Group—folks whose whole “thing” is about minimum costs—made this statement about HFT: “We believe the majority of ‘high-frequency traders’ play within the rules governing our current equity markets. We believe a majority of ‘high-frequency traders,’ which is not a defined term, add value to our current structure by ‘knitting’ together today’s fragmented market centers.” Given that Vanguard runs about $2 trillion, seems to me they would notice if this was a problem.
In summary, there are two major points here.
First, unless you’re directly involved in trading for institutions, HFT has been a cost-effective benefit for you, regardless of whether you believe HFT has been behind some of that. Trading fees and stock prices are all completely transparent. Spreads have been squeezed, execution times have improved a lot and commissions have been greatly reduced … all to the benefit of individual investors.
There are operational risks to trading at this speed in such a complex system as is our markets. They are, and will continue to be, addressed. And it remains the case that the U.S. stock market remains the most trusted and liquid in the world, as evidenced by the number of foreign and domestic participants.
Remember, as finance writer Michael Santoli phrased it, don’t be afraid of “dueling sets of software deep in the financial markets.” They’ve only been a net positive to you.
Michael Maehl is an independent financial adviser and Spokane-based senior vice president of Opus 111 Group LLC, a Seattle-based financial services company. He can be reached at 509.747.3323 or firstname.lastname@example.org.