High Frequency Trading

Does high frequency trading affect investors and should they be worried about it?

Yes. Investors are affected by high frequency trading when their mutual funds buy or sell stocks. Although this effect is minimal, nevertheless they should be worried about it because they are dealing with a system that is dishonest.

Stock exchanges facilitate risk transfer by providing price discovery. This secondary market function is an important part of our free-market system; it provides the liquidity that encourages investors to risk capital for new ideas. In more elaborate terms, the ability to transfer risk allows investors to construct portfolios that fit their individual investment objectives. Legitimately, this liquidity comes from myriad buying and selling of long-term investors, speculators and short-term traders—all who need price discovery when they decide to increase or decrease risk.

Peal back the onion one more layer. What do these diverse groups—long-term investors, speculators and short-term traders—have in common? They all take risk. One can’t trade or speculate without taking risk, even if the hold period is short. And long-term investors embrace several types of risk in their pursuit of growth and income: volatility and economic changes are examples. The point is that when an individual in one of these groups decides to initiate, increase, reduce or exit a position, the liquidity provided by the remaining participants—the marketplace—facilitates the price discovery and transfer of risk.

Trading frequently, therefore, is not the issue. The problem with today’s high frequency trading is that it eliminates risk at investors’ expense. The investment community spends millions on electronic equipment and pays millions more to exchanges for the privilege of placing this equipment at the front of the order flow. Simply stated, high-frequency-trading computers buy up stock at the offering price when they see a mutual fund’s order headed their way. Then they sell it to the mutual fund at a higher price when the order gets there.

(Yes, one must break up just one second into a million pieces to actually see what’s happening, but this is what’s happening.)

Whether or not high frequency trading is illegal has yet to be determined. Michael Lewis’ new book, Flash Boys, has brought the issue back into the limelight. Reportedly, the U.S. Justice Department, FBI and SEC are investigating. One route to declaring this practice illegal could be treating the mutual fund’s order as inside information: if one knows of the order before it gets there—even if just milliseconds—buying the stock ahead of time could be construed as trading on inside information.

Whether or not high frequency trading is ultimately determined to be illegal is not the issue: it is wrong. The new light bringing this issue to the fore is encouraging, but one should not be surprised to see little or no action by the regulators. Our nation’s investment system is invested in, committed to and profiting from the activity. Pardon the skepticism, but it seems a lot of wrongdoing can be overlooked when the incentive is large enough (like national football championships at Penn State, NCAA titles at UNC, collateralized debt obligations on Wall Street in 2006 and soaring stock prices at Enron). These analogies may be the equivalent of logical extremes, but the fact is it will take political courage to stop this corruption that is benefiting Wall Street at the expense of investors.

If regulators prove inept at resolving the issue, there may be a “live-by-the-sword-die-by-the-sword” solution. Namely, capitalism. A new stock exchange launched by Brad Katsuyama, the IEX, forces buy and sell orders to arrive at the same time, so the pricing scheme of high frequency traders is rendered useless. If interest in this new idea is any measure of the moral decay associated with high frequency trading, of note is that since Michael Lewis discussed Flash Boys on 60 Minutes (March 30, 2014), the IEX has received hundreds of job resumes and thousands of trading inquiries. Wouldn’t it be poetic justice if a better mousetrap removes a wart on our free-market system?

For the record, proponents defend high frequency trading by reminding us that electronic trading has lowered transaction costs exponentially for investors by reducing the spread between bid and ask prices from $.50 or $0.75 on large-company stocks to just a penny or two. Notwithstanding this fact, and legal or not, it still isn’t right to front run orders. Arguably, Charles Schwab Company—inventor of discount commissions—has done as much for the individual investor as anyone. Here’s what the company’s CEO, Walt Bettinger, has to say about high frequency trading: “…it is a growing cancer on the market that needs to be stopped.”

Sam Dreher
Founder
H.S. Dreher Capital Management, LLC