Lumping all speed traders together as predators and saying they rig the stock market exaggerates the hazards faced by investors, according to Arthur Levitt, who oversaw the Securities and Exchange Commission in the 1990s.
While Michael Lewis is hastening an overdue examination, his new book “Flash Boys” fails to differentiate between good and bad actors, said Levitt, who helped break a price-fixing plot among Nasdaq Stock Market dealers as chairman of the SEC.
“What is missed in the book and in the general discussion of HFT is there are some HFT traders who respect the sanctity of the investor, and some who don’t,” said Levitt, a Bloomberg LP director. “When markets tank, some HFT traders disappear like specialists and over-the-counter brokers used to disappear. On the other hand, some HFT traders are there for the whole game.”
Scrutiny of high-frequency trading is intensifying, with federal investigators examining whether firms violate U.S. laws by acting on nonpublic information, according to a person with knowledge of the probe. Federal Bureau of Investigation agents are examining whether traders abuse information to act ahead of orders by institutional investors, according to the person, who asked not to be named because the probe is confidential.
Levitt, the 83-year-old adviser to Goldman Sachs Group Inc., high-frequency firm KCG Holdings Inc. and the Promontory Financial Group LLC, headed the SEC during a period of transformation in American equity markets, including the adoption of uniform order handling rules and civil actions against Nasdaq market makers colluding to fix prices. Defenders say scandals like that one made today’s market inevitable.
Everyone who owns equities is victimized by high-frequency strategies, in which the fastest traders figure out which stocks investors plan to buy, purchase them first and then sell them back at a higher price, according to Lewis, who spent a year researching the topic. The U.S. stock market has been rigged by a group of banks, traders and exchanges using computers to prey on individuals, wrote Lewis, a columnist for Bloomberg View.
Levitt’s response was echoed by other professionals after Lewis depicted an industry bent on ripping people off.
“We find it extremely implausible that high-frequency trading as a whole is stealing tens of billions of dollars from investors, as Michael Lewis suggests,” wrote Patrick O’Shaughnessy, an exchange analyst at Raymond James & Associates Inc. “The implication that the U.S. stock market is rigged against the average investor is highly irresponsible.”
High-frequency trading comprises software-driven strategies that have spread from U.S. equity markets to most developed countries as computer power grew and regulators tried to break the grip of centralized exchanges. They usually employ super-fast computers to post and cancel orders at rates measured in thousandths or even millionths of a second.
Tactics described by Lewis in his book, in which speed traders use prices from the fastest exchanges to front-run slower ones, are known to regulators. O’Shaughnessy noted that staff of the SEC’s division of trading and markets published a report on March 18 reviewing 31 academic papers on HFT.
The paper, a survey of third-party literature with summary conclusions added by the SEC staff, outlined four basic strategies of high-frequency firms, including passive market making, arbitrage, directional, and a fourth, structural, that is similar to what Lewis describes when he depicts front-running.
“Structural strategies attempt to exploit structural vulnerabilities in the market or in certain market participants,” staffers wrote. “For example, traders with access to the lowest latency market data and trading tools may be able to profit by trading with market participants on a trading venue that is offering executions at stale prices.”
Two studies cited by staff found that more than half of HFT activity is “attributable to aggressive, liquidity-taking orders that trade immediately against passive resting orders,” with mixed results. That belies the idea that most of it is a benign descendant of market making, though some of it may be.
“In general, the HFT dataset papers find that primarily passive HFT strategies appear to have beneficial effects on market quality, such as by reducing spreads and reducing intraday volatility,” they wrote. “In contrast, the HFT dataset papers generally reveal that primarily aggressive HFT strategies raise more potential issues, with positive and negative aspects.”
While conceding not everything they do is evil, New York Attorney General Eric Schneiderman said yesterday that HFTs are engaging in a technological arms race that threatens to destabilize U.S. markets.
“We’re looking at if there is any other illegality,” Schneiderman said in an interview with Erik Schatzker and Stephanie Ruhle on Bloomberg Television’s “Market Makers” program. “High-frequency trading of securities, good -- produces liquidity. Front-running the market, bad,” he said. “The SEC is looking at this, and I’ve been in touch with the SEC. They need to make moves to change the regulatory structure.”
Schneiderman’s inquiry and now Lewis’s book threaten to disrupt a model that market regulators have permitted for years as high-speed trading and concerns about its influence have grown. Trading firms pay to place their systems in the same data centers as the exchanges, a practice known as co-location that lets them shave millionths of a second off transactions.
Lewis is adding his voice to a debate that has obsessed the securities industry for almost a decade while only periodically surfacing in public via events such as the May 2010 flash crash, when the Dow Jones Industrial Average lost almost 1,000 points.
“The United States stock market, the most iconic market in global capitalism, is rigged,” Lewis, whose books “Liar’s Poker” and “The Big Short” highlighted Wall Street excesses, said during an interview on “60 Minutes” March 30. “It’s crazy that it’s legal for some people to get advance news on prices and what investors are doing,” he said.
Firms using speed tactics account for about half of share volume in the U.S. Exchanges rely on HFTs for profits as well as liquidity, with electronic market makers all but eliminating human floor traders who used to oversee the buying and selling of equities. While critics such as Lewis see a Wall Street plot, proponents say the new system is faster and cheaper. “The statement that our markets are rigged against investors I think is hyperbolic,” said Levitt, who is also on the board of Motif Investing Inc.
Still, some of the regulations that allowed the stock market to be dominated by high-speed traders should be revisited and tested, Levitt said. There are probably too many dark pools and stock markets, and regulators ought to “think very carefully” about approving new venues, he said.
“There are new products and new trading techniques which the public doesn’t understand, even professional investors lack the understanding,” he said. “And I think that regulators have not adequately dealt with those trading techniques.”
Improved strategies for cloaking orders, decreasing market volatility and weakening share volume have squeezed profits for the HFT industry, according to Larry Tabb, the chief executive officer of Tabb Group LLC.
“If you take a look at high-frequency traders over the last five to seven years, the amount of revenue they collect has gone from about $7 billion down to about $1 billion,” Tabb said on Bloomberg Television. “If you look at the brokers, there are pink slips all over the place. The brokers’ ranks are getting smaller. Look who’s getting bigger. The investors are getting bigger, the hedge funds are getting bigger, the long-only.”
The practice of selling enhanced access to brokers accelerated as American exchanges evolved from member-owned firms amid a flurry of regulation and computer advances in the 1990s. Among other changes, the government-mandated compression of stock price increments to pennies from eighths and sixteenths of a dollar, a process known as decimalization, squeezed profits for market makers and specialists that had overseen stock trades.
Faced with the need to maintain liquidity on electronic platforms where profits were too fleeting for humans to capture, exchanges encouraged computerized firms to post orders for investors to trade against. Co-location and customized data feeds developed alongside the hodgepodge of fees and rebates that market operators use to keep speed traders coming back.
“HFTs are more likely than not to be providing you liquidity, lowering your trading cost,” said Michael Mendelson, a principal at AQR Capital Management, which is a longer-horizon investor and does no high-frequency trading. “At the same time, other HFTs are trying to figure out what the large, professional traders are doing, which ultimately helps the little guy avoid getting run over by the big guy. Either way, the big winner has been mom and pop.”