When high-frequency traders defend themselves against criticism that they’re screwing up the stock market by distorting prices or making it more volatile, their argument usually goes like this: Yes, but we’ve lowered the costs of trading. Which is true, in a way. The bid-ask spread for many stocks—the difference between what it costs to buy or sell a share—is often just a penny, much narrower than it used to be. As speed traders have proliferated over the last few years, they’ve made the U.S. stock market considerably more liquid, meaning there’s almost always someone willing to take the other side of your trade.
The problem is that when slower, long-term investors try to buy or sell shares, they often find themselves at the back of the line. They are leapfrogged by thousands of lightning-quick traders who make their living jumping in and out of shares of “ultra liquid” stocks such as Bank of America. Stuck behind this churning scrum of algorithmic traders, normal buy-and-hold investors have to wait to execute their trades for the highest-volume stocks, which often results in worse prices.
Not only that, but slower, “directional” investors (those who actually take positions in stocks) get crowded out from providing liquidity and collecting rebates from exchanges. This, according to a new study (PDF) by Pragma Securities, a New York-based firm that builds trading algorithms, costs them a lot of extra money—about $2.5 billion a year, estimates Pragma’s chief executive officer, David Mechner. “That’s the upper bound of magnitude,” he says. “But it’s definitely in the billion-dollar range.”
The Pragma study raises a question that cuts to the heart of the controversy surrounding speed traders: How can they simultaneously make trading more efficient and raise trading costs for long-term investors, all the while pulling billions out of the markets in trading profits? The answer lies in a strange paradox: The most-heavily traded stocks—Bank of America, Ford, Microsoft—are actually some of the most expensive to trade. Not because their prices are high but because demand for them is so high.
There’s a reason that thousands of high-speed traders pile in and out of the same stocks every day. Those stocks all tend to have low volatility, meaning there’s less chance the price will dramatically change and catch HFTs with a loss during the few seconds they actually hang onto the stock. They all tend to have relatively low prices. As the Pragma study points out, low prices are attractive because HFTs that quote both a bid and a sell price in stocks make money off a tiny spread, plus the rebates they’re paid by the exchanges to provide liquidity. Their return is greater if they’re making a couple of pennies trading a stock at 7 than at 500.
This shows up in the amount of volume for ultra-liquid stocks. BofA, which trades between 7 and 8, is the most heavily traded stock in the U.S., with an average of 257 million shares moving per day. Only about 18.8 million shares of Apple, which hovers between 500 and 600, trade daily. According to Pragma, it takes the slowest investors 138 seconds to execute a trade for shares of BofA. That might not seem like a long time, but in a computer-driven market whose fastest traders can move in and out of stocks in a matter of microseconds, it’s a lifetime.
This waiting means that some long-term investors get elbowed out of their old role as market-making liquidity providers. In many instances when they want to build a position in a stock, they have to go through HFT market makers such as Getco or Citadel, and they end up paying the full spread rather than filling it themselves by matching a bid to a bid or an ask to an ask.
The question is whether the benefits speed traders bring to the market outweigh the added costs and trade-offs. Even if slightly longer wait times are costing long-term investors billions a year, having a more liquid market with tighter spreads has saved them that much, if not more, says Rick Cooper, a professor of finance at the Illinois Institute of Technology’s Stuart School of Business. Cooper used to work for long-term investors, building early algorithms and quant models for State Street Global Advisors. He doubts they want to go back to the old days, when they were beholden to a small, clubby group of broker dealers serving as market makers. “Back in the day, when demand spiked, they would widen out the spread on you,” says Cooper. “It used to take us days to execute some of our big trades so we wouldn’t move the price.”
These days, any time a market maker tries to widen out the spread, an electronic market maker usually jumps in and tightens it up again.
Besides, Cooper says, long-term investors are betting on the direction a stock will take over the course of months or years, not seconds. Paying an extra penny and waiting an extra few seconds probably doesn’t matter to them. “These long-term investors who are sitting on trillions of dollars—these pension funds and mutual funds—they just want to get their trades in and out and without much cost. They’re not worried about paying an extra penny. They just don’t want to move the price with their big order.”