The Wall Street Journal on Friday led off with a story describing a Securities and Exchange Commission probe into high-frequency trading. What's immediately striking about the story is not that there is an investigation -- albeit one that's the usual "still in its early stages" -- but that the story pitches it so narrowly. The agency, according to the paper, is examining whether "some sophisticated, rapid-fire trading firms have used their close links to computerized stock exchanges to gain unfair advantage over other investors, people familiar with the matter say." This turns a large, complex and important issue into a kind of insider-trading scam. The SEC is not asking whether HFT trading makes any sense, or whether it creates distortions and broad opaque swaths of the market, but whether one trader gets a little -- a very little, though in this surreal world of millisecond trading, a little may mean a lot -- edge on another.
The Journal story raises all kinds of issues. In a world where speed is everything, how do you define "advantage"? Obviously, technology creates a multi-tiered playing field here, with the edge going to those who can spend on technology. Is the SEC looking into traditional malfeasance -- the usual seamy kickbacks or bribes -- or the more esoteric: faster portals into exchange servers for certain select customers? This range of "advantages" may be built into the very concept of HFT. Will the SEC put HFT itself on trial?
How strange is HFT? Very. Consider that, according to a speech last July titled "The Race to Zero" by the Bank of England's executive for financial stability Andrew Haldane, the technology race that is HFT has actually gone beyond the point where nothing but the most powerful technology matters (this was the view some eight months ago; who knows how it has changed since then). Trading times have gotten so fast that physical proximity to exchanges -- so-called co-location -- begins to loom as a key performance factor. Writes Haldane: "HFT firms have begun to relocate their servers as close as physically possible to the trade-matching engine. That allows them to eke a pico over their (non co-located) competitors." Haldane draws out the relationship in a high-speed world between "information" and "speed."
In a high-speed, co-located world, being informed means seeing and acting on market prices faster than competitors. ... Those uninformed traders face a fundamental uncertainty: they may not be able to observe the market price at which their trades will be executed. Co-location speeds up the clock. But it also has the effect of turning it back. Location matters once more. The race to zero has become a physical, as well as a virtual, one.
Haldane's speech is a marvel of clear writing and insight (hat tip to Harvard Business Review's Justin Fox, who penned a deserved appreciation for Haldane several weeks ago; all of Haldane's speeches can be found here). Haldane ranges broadly, moving from trading microstructure to macrostructure. He does what the SEC appears to resist: Taking a hard look not only at HFT, but at the equity markets more broadly. This goes well beyond questions of whether someone benefits unfairly and into what broad effects this "drive to zero" by the HFT crowd may be having on the market in general, including so-called low-frequency traders -- that is, the rest of us. Haldane sketches the historical background: the recent breakdown of central exchanges and the rise of "a diverse and distributed patchwork of exchanges and multilateral trading platforms," including dark pools. The average speed of execution in the U.S. has fallen from 20 seconds a decade ago -- so long! -- to around one second. HFT trading has gone from less than 20 percent of U.S. equity volume to between two-thirds and three-quarters.
Much of Haldane's speech focuses on an examination of the Flash Crash, as apparently does the SEC probe. I'm not going to trace the marvelous twists and turns of Haldane's logic, though he does manage to link Benoit Mandelbrot's work on fractal geometry to the work of British civil engineer H.E. Hurst on the patterning of Niles floods to episodes of liquidity and illiquidity -- and make it work. Haldane concludes that this race to zero raises a variety of inventory and information problems, from a clustering of volatility episodes that create illiquidities to greater uncertainty and execution risk for all equity investors.
If the way to make money is to make markets, and the way to make markets is to make haste, the result is likely to be a race -- an arms race to zero latency. Competitive forces will generate incentives to break the speed barrier, as this is the passport to lower spreads, which is in turn the passport to making markets. This arms race to zero is precisely what has played out in financial markets over the past few years. Arms races rarely have a winner. This one may be no exception. In the trading sphere, there is a risk the individually optimizing actions of participants generate an outcome for the system that benefits no-one -- a latter-day "tragedy of the commons." How so? Because speed increases the risks of feasts and famines in market liquidity.
So where is all this going? Again, this is not just about one interest gaining an advantage over another. It's also about the role equity markets play in so many facets of the economy. In another speech on bank governance -- "Control Rights (and Wrongs)" -- Haldane focuses in on the centrality of equities as a performance measure (and shareholders as drivers of risk) and as an instrument of increasing historical short-termism.
Bank equity holding periods have been declining since the '70s and the deregulation of brokerage commissions in the U.S. But if anything, it seems to be accelerating, driven most recently by HFT: Share holdings in U.S. and U.K. banks have fallen from three years in 1998 to three months in 2008. Clearly, much of this volume is highly speculative in nature, with much of the traditional ballast of long-term holdings tossed overboard. Going beyond crises like 2008 or the Flash Crash raises the question of how our equity markets, so radically different from that of say the '80s, not to say the '60s, affect everything from management performance to longer-term investment. Is there a link between these changing markets and the disappearance of the equity risk premium in the last decade or so? Do larger concerns about initial public offerings and capital allocations trace themselves back, at least in part, to steroidal equity markets? How does the market economy affect the macroeconomy?
In short, have we turned virtue into vice, plenty into excess, efficiency into the race to zero? For the third time, I'll turn to Haldane, who offered up a marvelous meditation called "Patience and Finance" (this from a central banker!) in 2010 to an audience in Beijing that not only touched on many of these issues but then explored them. His last lines drift into the realm of a vaguely ancient Greek-like philosophy of equipoise and balance:
Just as patience can ward off great disaster, impatience can ruin a whole life. Generations of dieters and addicts are testament to that. So too is finance, not least in light of the crisis. It is important [that] finance sticks to the evolutionary path. To do so, the fidgeting fingers of the invisible hand may need a steadying arm."
Robert Teitelman is editor in chief of The Deal magazine.