"The truth is rarely pure and never simple." - Oscar Wilde
In this post, I address the assertion by Michael Lewis during his 60 Minutes interview and in his new book, "Flash Boys," that the market is "rigged" by high-frequency traders.
So, is the stock market "rigged"?
No. But, as Mr. Wilde said, the truth isn't pure or simple.
The market isn't rigged in the sense that direction of stock prices are controlled or somehow understood by some participants and not by others. Mr. Lewis made an overstatement. I'll stop there because I haven't read his book. But I'm tempted to go further and say his saying the stock market is rigged is inflammatory and a gimmick to sell more books. If the market were truly rigged, traders would have to be able to profit unfairly by knowing how prices will move in the future. HTFs don't have that kind of edge. The edge they have is slightly different.
If the market is rigged, it's rigged by the Federal Reserve on behalf of itself, the largest banks and the government. But that's a subject for my next post.
The edge HFTs have is that they can measure order flow in markets and move faster than many other participants giving them the ability to outmaneuver other traders. They've achieved this by building ultra-fast computers working on ultra-fast networks linked by high-capacity connections to the exchanges. They're not doing anything illegal. The question is shout it be? On the surface, the answer is probably, yes. But HFT isn't the kind of issue you can address by looking at the surface. Understanding HFT and how/if to regulate it requires deep understanding and thoughtful analysis - something governments try endlessly to do but are notoriously terrible at doing.
Before one can have a well-informed opinion on whether HFT should be prohibited, regulated or neither, one must think about many other important questions, such as: Do HFTs serve anyone but themselves? What value, if any, do they provide to non-HFT investors? Which investors do they provide value to? Which investors do they harm? What costs are being imposed on non-HFT investors? How would the markets function without HFTs? What would the transition to a market without HFTs be like? Could government outlaw HFTs effectively? Could government regulate HFTs effectively? What would prohibition or regulation look like? How much would it cost the government to enforce it? Where would that money come from? Would the costs outweigh the benefits?
These questions are important and hard to answer. I have opinions on some of these questions, but I'm far from convinced on most of them.
The fact is HFTs are "skimming" money from investors. Several years ago, the founder of Tradebot, one of the biggest high-frequency firms, had said that the firm had "not had a losing day of trading in four years." Some call it legalized theft. I don't argue with that characterization, but, unfortunately it doesn't make HFTs any easier to deal with.
Yes, HFT is a cost to investors. Yes, HFT is encouraged by the exchanges because they like the source of revenue. And, yes, HFT is allowed by the SEC. Why the SEC allows it isn't clear. I'm a devoted skeptic of government and top-down, central planning, but, in the case of HFT, I think government is right to be skeptical of the potential solutions because medicine could be worse than the disease. Especially if the medicine is too strong.
The cost HFTs impose on investors is small. In fact, investors get better order executions today than they have ever had before. These aren't points in defense of HFT. These two points, along with all questions I listed above are the reasons HFT hasn't been regulated or outlawed yet.
In a report published in December of 2012, called, "High Frequency Trading -- The Good, The Bad, and The Regulation," Credit Suisse concluded that although high frequency trading is often viewed as entirely negative not all behaviors are detrimental to the market and HFT has probably led to an improvement in market quality overall. They also concluded that, "it is clear that undesirable behavior exists" and suggested some possible regulations to improve the marketplace while also warning against other regulations that "seem prone to unintended consequences, especially where their scope is broad."
