Michael Lewis Doesn't Like High-Frequency Traders
I suppose one way to evaluate your life is to ask yourself, would I be the hero of a Michael Lewis book, or the villain? Am I a clever young outsider applying rigorous quantitative thinking to revolutionize a stodgy stupid business that is bad for its customers, or am I, you know, the stodgy stupid one?
Brad Katsuyama is the latest Michael Lewis hero, which is nice for him. I haven't read Lewis's new book yet, but "60 Minutes" had a segment on it last night, and here is an excerpt. Katsuyama was an equities trader at Royal Bank of Canada who discovered one day that the equity markets were rigged. Big mutual funds that wanted to buy a lot of shares found that it was hard to do so at displayed prices: As soon as they started buying shares, the price started to go up.
Being a nice young Canadian -- "60 Minutes" called him "a conformist even by Canadian standards" -- Katsuyama decided to unrig the markets, offering fair trades at a fair price to everyone. So he left RBC and started a IEX, a dark pool
with unusual transparency and rules intended to protect orders from being picked off. The idea is that if you're a big mutual fund and you submit an order on IEX, that order will not provide any information to high-frequency traders for almost a whole millisecond. (A shoebox full of wires is involved, which everyone else seems to find more interesting than I do.) The result is that HFTs won't be able to react to your order by moving up prices on other exchanges, and you'll be able to execute more shares at the displayed price.
Katsuyama was received as a hero by institutional investors, Goldman Sachs and Michael Lewis. The investors you can understand; their favorite pastime seems to be buying a lot of shares at displayed prices. Goldman is a little weirder -- IEX competes with Goldman's own dark pool -- but Goldman is into market-structure fairness these days. Michael Lewis -- I mean, this excerpt has some hurtful things to say about dark pools, so it's odd that his hero is a dark pool operator,
but the story is actually pretty compelling. Young nice whippersnapper takes on the establishment and makes life better for everyone, etc. I just ordered the book.
While I wait for it to arrive, though, let me spin for you an alternative Michael Lewis story. This one starts with a bunch of stodgy old banks filled with the sorts of equity traders whom you might recognize from "Liar's Poker." "Liar's Poker" has nothing nice to say about equity traders at big banks. In this story equities, in Dallas or otherwise, is not an intellectual power center.
But it's a simple operation. A trader quotes a stock, Microsoft say, bidding to buy it for $39.95 and offering to sell it at $40.00. 3 If a big seller hits the bid, the trader owns a bunch of Microsoft stock at $39.95, and then tries to resell it at a profit. 4 He does this using his gut instinct: If there's a big seller, that means the price should move down, so the trader might lower his quote to $39.93 bid, $39.98 offered, hoping to sell at $39.98 and make some profit. If the seller is really big and really informed, the trader might move his quote down faster, because you don't want to be on the other side of the market from a big informed seller. On the other hand, if the seller is a small retail order, the trader might not move his quote at all: Uninformed small orders are basically random, so for every one of those who sells to you at $39.95, another will buy from you for $40.00, making you a big profit. 5
If the trader's instinct is good, he'll make his spread trading with a lot of uninformed orders. If he's less good, or unlucky, he'll get picked off: He'll buy from big smart institutions for $39.95 when the "right" price is $39.90, and he'll end up with a big loss. Overall, though, it's a lucrative business, because the spread is wide enough to make up for the times that the trader loses.
Then along come some smart young whippersnappers who replace gut instinct with statistical analysis. Instead of relying on some equity trader's ample gut to guess what orders are likely to move the market, you can use a computer to figure it out, and then automate how you trade. If you build your computer right, you won't be blindsided by informed orders that go against you, like a lot of mortgage-backed securities traders were. 6
And this means that you can quote a much tighter spread: By being smarter than the competition, you can also be leaner and more efficient. You might quote Microsoft at $39.97 bid and $39.98 offered on every exchange, knowing that as soon as someone hits your bid on one exchange, you can instantly move your market down to $39.96/$39.97 everywhere else. This reduces your risk of being picked off by trading with informed traders, which lets you make a profit even on much narrower spreads. You can charge less to trade by being more informed.
There are two ways of characterizing high frequency trading. In one, HFTs are front-running big investors, rigging the game against them and making the stock market illusory. In the other, HFTs are reacting instantly to demand, avoiding being picked off by informed investors and making the stock market more efficient. 7
In my alternative Michael Lewis story, the smart young whippersnappers build high-frequency trading firms that undercut big banks' gut-instinct-driven market making with tighter spreads and cheaper trading costs. Big HFTs like Knight/Getco and Virtu trade vast volumes of stock while still taking in much less money than the traditional market makers: $688 million and $623 million in 2013 market-making revenue, respectively, for Knight and Virtu, versus $2.6 billion in equities revenue for Goldman Sachs and $4.8 billion for J.P. Morgan. Even RBC made 594 million Canadian dollars trading equities last year. The high-frequency traders make money more consistently than the old-school traders, but they also make less of it.
You don't have to be absolutist about this either way. Whether or not HFTs' behavior of quickly adjusting quotes to market conditions is "predatory" in some moral sense -- and whether or not it ultimately makes markets more or less efficient on balance -- it is clearly annoying to a lot of institutional investors. So those investors like having the option of trading on IEX. And there's no obvious reason to think that the current market structures and rules are the "right" rules, or that high-frequency traders aren't sometimes gaming those rules in not-so-socially-optimal ways.
Still, I don't know, I feel a little sorry for the HFTs. They check a lot of the right boxes to be the heroes of their own Michael Lewis stories. It's sad for them that they instead turned out to be the villains of someone else's.
Is this a little mean? From the website: "At launch IEX began operations as a non-displayed ATS but, at a date to be announced, IEX plans to convert from an ATS to an ECN and publish a displayed quotation." Bloomberg News called it "a dark pool that plans to convert into a U.S. stock exchange."
Again, a little unfair. See footnote 1 above, and also, the hurtful things are about nontransparent dark pools operated by brokers. IEX has transparent rules and isn't owned by a broker; it just happens not to display quotes.
Here's a 2001 paper finding 3.5 cent to 7 cent spreads depending on how you count.
Lewis on Katsuyama:
His main role as a trader was to play the middleman between investors who wanted to buy and sell big amounts of stock and the public markets, where the volumes were smaller. Say some investor wanted to sell a block of three million Intel shares, but the markets showed demand for only one million shares: Katsuyama would buy the entire block from the investor, sell off a million shares instantly and then work artfully over the next few hours to unload the other two million.
If you're going to Amazon anyway, this is where I learned most of my market microstructure.
See what I did there? Some of those were a stretch, though I insist on the Moneyball one.
In the New York Times excerpt, Lewis describes three types of predatory HFT behavior:
The third, and probably by far the most widespread, they called slow-market arbitrage. This occurred when a high-frequency trader was able to see the price of a stock change on one exchange and pick off orders sitting on other exchanges before those exchanges were able to react.
But his "pick off" is the HFT's "avoid being picked off." If a big informed investor buys Microsoft for $40.00 on one exchange, that should move the price up. An HFT who leaves a $39.99/$40.00 quote on other exchanges is now offering to trade at the wrong price. Trading at the wrong price is bad for business.
(Matt Levine writes about Wall Street and the financial world for Bloomberg View.)
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