Winston Churchill once famously commented that his critics reminded him of a story about a sailor who jumped into a dockside bay to rescue a small boy from drowning. About a week later this sailor was accosted by a woman who asked, "Are you the man who picked my son out of the water the other night?" The sailor replied modestly that he was. "Ah," said the woman, "you are the man I am looking for. Where is his cap?"
Like the boy’s mother failing to appreciate the actions of the sailor, the critics of high frequency trading fail to appreciate the major contribution that traders employing high frequency strategies have made towards ensuring that our nation’s equity markets the world’s most fair, transparent, resilient and lowest cost.
Specifically, a chorus of critics have recently begun asserting that so-called "high frequency" traders, which now make up approximately 60 percent of trading volumes in the United States equities markets and provide critical liquidity to all investors, are harming the market with unfair, speculative trading that causes stock prices to needlessly fluctuate to the detriment of investors.
Variations of this concern have been raised by some very educated and well-intentioned market observers, causing the Securities Exchange Commission and some Congressional staff to begin a more thorough examination that could lead to actions designed to reduce, eliminate or inhibit the use of high frequency trading strategies.
Ironically, acting on the critics’ concerns and inhibiting high frequency trading would actually create the type of market reactions that the critics profess to be concerned about, causing considerable economic harm to individual investors, large institutions and, ultimately, to our nation’s economy.
Historical Background
To understand high frequency trading and the criticisms of it, it is first useful to review some recent equity market history. In 1996, the Justice Department found that 24 major Nasdaq market makers engaged in "an industry-wide practice that fixe[d] transaction costs" and "anti-competitive conduct which resulted in higher trading costs for individual investors and institutions who bought or sold stocks."
Similarly, in 2003 the Securities and Exchange Commission reached a settlement with five New York Stock Exchange specialists for violating federal securities laws and exchange rules by executing orders for their own dealer accounts ahead of executable public customer orders.
Even CALPERS, the largest public pension plan, filed suit against the specialists for employing "artifices to defraud" and arguing "that NYSE orders were not filled at the best available prices" and, instead, were executed in a way that "financially advantaged" the specialists. In the wake of these scandals, the SEC adopted regulations that fostered competition with the traditional market makers and specialists which had dominated Wall Street for generations.
One of the key SEC changes required market makers or specialists to publicly display the best priced limit orders to buy or sell, regardless of whether the order was entered by an individual or an institution. No longer did the market maker or specialist control investor access to the pricing information that is critical to a fair marketplace. During the same time period, another important set of SEC regulations fostered the creation and growth of all-electronic alternative trading systems (known as "ATSs").
These two reforms complemented each other as the technologically advanced ATSs facilitated the immediate public display of the best priced limit orders, reducing the opportunity for the type of wrongdoing that led to the previous scandals.
These two key SEC reforms fostered the emergence of a new breed of professional trader that began competing with the traditional Wall Street market makers and specialists by using automated computer programs to enter orders directly into the market. These traders who came to be known as "high frequency traders" relied on technology and detailed analysis to provide better prices to investors.
Instead of being clustered in lower Manhattan, they were spread out all over the country. Where the old guard had one trader pecking away at a keyboard and covering 15-20 stocks, these nimble and efficient high frequency traders could use computers to trade thousands of stocks simultaneously.
The efficiency of these automated systems allowed the high frequency traders to earn profits even when eking out razor thin margins of just fractions of a penny per share rather than the 5 or 10 cents per share traditional Wall Street traders were accustomed to making.
The overnight change in the trading patterns of the Nasdaq 100 Index in 2001 highlights the competitive impacts of the SEC reforms and foreshadowed the dominance of the high frequency traders and all-electronic marketplaces. At the time, the ETF for the Nasdaq 100 Index (then known as the QQQ) was the most actively traded security and was primarily traded on the American Stock Exchange which utilized a manual floor-based specialist system. Using ATSs, the high frequency traders began using their efficient automated trading systems to narrow the quoted spreads in the QQQ from several pennies down to tenths of a penny, saving investors millions in the process.
Within months, investors voted with their feet and made the electronic markets that featured the liquidity and narrower spreads of the high frequency traders the dominant venues for the QQQ. Investors never looked back. Ultimately, the NYSE and the Nasdaq Stock Market were compelled to purchase these electronic markets that catered to high frequency traders (Archipelago was purchased by the NYSE and INET by the Nasdaq Stock Market). The traditional, uncompetitive Wall Street market maker model was replaced and the exchanges were transformed to open, fair and transparent electronic marketplaces.
Addressing How Investors Benefit & Critics
Lowering Trading Costs: Investors have reaped the benefits of the SEC reforms that led to the rise of high frequency traders and electronic markets. The most obvious direct benefits to investors are reflected in the dramatic reductions in trading costs and spreads over the past 10 years.
Thanks to the increased competition and efficiency, commissions paid per transaction by individual investors dropped from hundreds of dollars to just a few dollars. Similarly, execution quality as measured by the difference between the highest bid and lowest offer (known as the "spread") has compressed to levels unthinkable prior to the reforms, meaning that investors have less money taken out of their accounts to cover trading costs when buying and selling.
Greater Liquidity Benefits
In addition to these often mentioned benefits, less direct but substantial benefits have also been realized by investors and, indeed, our overall economy from the improved efficiency of the markets brought about by the emergence of both competitive electronic markets and high frequency traders. One invaluable benefit to investors is the dramatic increase in trading volume, which makes it easier for investors to cheaply buy and sell securities.
Some critics contend that the rise in trading volume and the substantial market share of high frequency traders is evidence that the markets have become tools for speculation. But what these critics misunderstand is that professional traders have always been a large percentage of the volume.
These intermediaries bridge the fluctuations between supply and demand that occur throughout the trading day. If only long-term investors were trading securities, there would not be adequate liquidity to keep markets stable and spreads narrow. Therefore, market intermediaries, whether traditional market makers and specialists or today’s high frequency traders, are essential.
Further, the overall increase in trading volume is not solely attributable to high frequency trading but is due to an increase in trading by all types of investors. Simply put, when something gets cheaper and easier, people tend to do it more. The substantial increase in passenger miles following airline deregulation in the 1980s provides an instructive analogy. Air travel didn’t increase because people suddenly had more relatives or vacation time but because, as ticket prices dropped and flights became more plentiful, demand for air travel increased. Similarly, the rise in trading volumes is because of the elimination of unnecessary barriers to trading, such as the manual intervention of a specialist, wide spreads, and high commissions have made trading more affordable.
High frequency traders do not create the increased demand to trade. Instead, like the airlines adding flights to satisfy growing demand, the growth in high frequency trading volume is in response to increased investor demand.
The increased liquidity (i.e. the ability to easily buy or sell a stock without significant price impact) provided, in part, by high frequency traders means that fund managers can now more easily adjust their portfolios to reflect their fundamentally based views on company performance rather than being prevented from buying or selling a particular company’s stock because of high trading costs due to a lack of trading volume.
Consider a stock of a well-managed mid-cap company that prior to the regulatory reforms and the participation of high frequency traders had an average daily volume of 200,000 shares. With this relatively small trading volume, any attempt by a fund manager to reward the good management of the company and purchase the stock would have a relatively large impact on the share price.
If purchasing a significant number of shares, the fund manager would need to spread purchases out over days or weeks, which discouraged the purchase of the company’s shares in the first place. And even if the fund manager decided to purchase the stock, the insufficient trading volume could make it too difficult to sell quickly if the company’s prospects changed.
In contrast, if the same stock now trades 2 million shares per day, it is easier for a fund manager to efficiently allocate capital and reward management for its performance by purchasing the company’s stock.
The fund manager can comfortably add shares to his fund knowing both that his purchases will have a smaller impact on the market and that it will be less costly to sell the stock should it become necessary. In short, the critics are hard pressed to explain how the investor buying or selling a company’s stock would be better off with fewer high frequency traders providing liquidity any more than a consumer in need of gas would be better off if there were fewer gas stations.
Accelerating Price Discovery Benefits All Investors
Some critics, however, still maintain that, while greater liquidity is valuable in theory, market participants with large orders (and the individual investors they often are representing) are nevertheless harmed by high frequency trading. In simple terms, these critics assert that when, for example, they try to purchase a large quantity of IBM shares, high frequency traders detect the buying interest and cause the price of IBM to rise before they can finish purchasing all the shares they desire.
The critics admit that the high frequency traders do this by statistically analyzing the same information available to every investor and not through any inappropriate or illegal source. Nevertheless, they claim that since this may increase their execution costs, it is bad for them and the investors that they often represent.
A closer look, however, reveals that these critics are actually arguing in favor of inefficient markets. A healthy market is supposed to reflect all known information about a stock, including supply and demand. The fact that an investor is buying a large number of IBM shares obviously impacts demand and should, in an efficient market, trigger a rise in the stock price.
The critics of high frequency trading, however, are essentially saying that the market should stop following the laws of supply and demand when they want to buy or sell so they can get a better price than they otherwise should. The logical conclusion of their claims is effectively that, when market participants, including high frequency traders, forecast a probable price change in a stock, they should nevertheless treat that information like one treats a young child during a game of hide and seek. Namely, these critics want everyone else to pretend that they don’t detect a change in supply or demand even though they can see the figurative leg sticking out from behind the couch!
What the critics don’t explain, however, is how an investor’s desire to buy large quantities of stock without causing the price to increase helps anyone else in the market. If market participants must ignore the increasing demand, then what happens to the individual investor or institution that wants to sell during the period when basic economic principles are suspended?
Specifically, keeping the price of IBM artificially low to facilitate the large buy order would, by definition, disadvantage every seller of IBM at that time. Those disadvantaged sellers could include an institution (trading for individuals) or individual investors directly. In essence, some market participants that enter large orders want other market participants to subsidize their trading.
Putting this concern in another analogous context lays bare the self-interest of this argument. Consider a developer of a shopping mall that needs to buy the land of existing homeowners. The developer would not want the homeowners to know of its plans since the homeowners would almost certainly increase their asking price. Consequently, the developer may try to surreptitiously buy the land from the homeowners to avoid any information leakage.
While acquiring the land cheaply benefits the developer and his shareholders, the same cannot be said about the homeowners. The homeowners would realize a considerable gain if the market immediately reflected all information affecting the market value of their homes. Should rules be adopted that favor developers over homeowners?
The investor with a large order is no different than the developer in its desire to purchase or sell stocks without having a market impact. But this desire should not come at the expense of another investor.
Markets operate far better when they reflect all information instantaneously. High frequency traders play an important role in that process by accelerating the reflection of all information to the broader market. So while there is no empirical evidence showing that market impact of large orders has really increased due to high frequency trading (in fact, studies from Hendershott and Riordan in 2009 as well as the Board of Governors of the Federal Reserve System suggest that high frequency trading lowers volatility), the real question is why an increase which reflects the acceleration in the dissemination of information is a bad thing. In other words, why would we want to artificially constrain stock prices so they fail to reflect all available information when the net effect is to benefit one market participant to the detriment of others?
Reducing Market Volatility
Other critics may agree that accelerating price discovery is useful, but they argue that high frequency traders cause an unhealthy increase in market volatility, "whipsawing" prices around to benefit themselves at the expense of investors. These critics buttress this argument by pointing to the perceived increase in high frequency trading firms in the past year and assert that these new entrants can only profit by causing needless price swings and at the expense of long-term investors.
These critics don’t have a leg to stand on. The principal way that academics and market participants evaluate the relative rate at which a stock price moves up or down is through a concept known as volatility. Higher volatility is associated with greater price movements and lower volatility would signal more stable prices. No serious market observer disputes the claim that volatility would not be higher without the liquidity provided by high frequency traders.
The volatility reducing effect of high frequency trading was highlighted during the recent ban on short selling. When all short sales in financial stocks were suddenly banned, high frequency traders either reduced or stopped trading the impacted financial stocks. The result? A substantial increase in volatility and spreads, increasing trading costs for all investors.
The curbing of high frequency trading didn’t stop the stock prices of those companies from continuing to plummet; in fact, the declines accelerated. But when the short sale ban was rescinded and the high frequency trading volume fully returned, volatility and spreads improved meaningfully.
Despite the experience with short sales, the critics continue, nevertheless, to assert that high frequency traders are adding damaging short-term volatility. Using the shopping mall developer example, the critics assert that if the current value of the land is $20 per square foot but the developer was willing to pay $100 per square foot, that the high frequency trader would briefly push the price past fair value to $120 per square foot before it settled on the new fair value of $100.
But this conclusion is not supported by the evidence. In fact, the few studies that are based on data sets that enable a detailed analysis of high frequency trading activity relative to all other market participants (including one by the Board of Governors of the Federal Reserve System) found that high frequency traders actually lowered short-term volatility and that high frequency traders were more likely than the rest of the market to push stock prices towards fair value.
Further, like the other criticisms, this assertion can also be evaluated logically. High frequency traders can only trade profitably when their trades push a stock price towards fair value. If a stock price were truly "overreacting" to a large buy order or were otherwise needlessly pushed around by high frequency traders then another high frequency trader would detect this "overreaction" in the stock price and quickly push the price back down to fair value.
As a result, any high frequency trading strategy that consistently pushed a stock price beyond its fair equilibrium price would, over time, lose money. The overreaction argument fails to take into account that there are scores of high frequency traders aggressively competing to ensure stocks trade at their fair equilibrium price. The main impact of the increase in high frequency trading firms is more competition, lower profit margins for high frequency traders, and lower transaction costs for investors. In short, allegations that high frequency trading adds volatility are not supported by academic research or common sense.
The Benefits of Short-Term Professional Traders
The final bogeyman raised by critics is that high frequency traders are simply the latest speculators on Wall Street and that we have to deal with the "short-termism" of the high frequency traders before they cause another bubble and subsequent crash. While some kinds of risky speculation are real concerns and should be taken seriously, speculation has nothing to do with high frequency trading.
The kinds of dangerous speculation that lead to the recent financial crisis involved the making of large bets by taking large, risky illiquid positions. The recent experiences of banks that held large illiquid portfolios of mortgage backed securities highlights the risks associated with that type of long-term speculation.
In contrast, in fulfilling their role of providing liquidity to investors and accelerating the price discovery process, high frequency traders trade in and out of positions and have holding periods that often can be measured in seconds or minutes. Further, high frequency traders are market neutral and generally don’t carry any positions overnight. In so doing, high frequency traders actually are taking very calculated and narrow market risks. Viewed in this light, high frequency trading is the "polar opposite" of speculation.
Further, "short-termism" is not a negative but, rather, is an important positive attribute of a high frequency trader. When considering other professional intermediaries (think grocery stores, gas stations and car dealers) in our economy, it is immediately apparent that all of them are in some sense short-term investors. Just as nobody would fault a grocery store or gas station owner for not being in the business of investing for the long-term in food or gas, it is similarly nonsensical to fault a high frequency trader for not "investing" in stocks.
High frequency traders are not in the business of stock investing but are service providers, providing liquidity and transparent price discovery to all investors. Without high frequency traders, trading costs would go up for all investors, making our capital markets a less attractive alternative for capital raising and pushing companies into overseas markets or into issuing debt.
Conclusion
As the past regulatory actions against the traditional Wall Street traders and the rapid emergence of electronic markets demonstrate, investors prefer a fair and transparent trading environment to one that favors a select group over other market participants. Accordingly, any debate about electronic markets and the role of high frequency traders must be viewed in light of the un-controvertible fact that our nation’s equity markets are far fairer, more efficient, more liquid and have lower transaction costs for investors than ever before.
And it must be further recognized that high frequency traders, as the heir to the roles played by the traditional market makers and specialists, are responsible for a significant portion of this dramatic improvement along with the Securities and Exchange Commission which worked to create and nurture the fair, transparent and efficient environment we enjoy today. So while there is always room improvement, let’s not fail to appreciate – like the mother in Churchill’s story – why our equity markets are the envy of the world by focusing on the equivalent of the boy’s cap.
Cameron Smith is the General Counsel of Quantlab Financial LLC, a Houston-based Quantitative technology and trading company.
