Is Technological Innovation an Unfair Advantage?
Ever since the 2010 “Flash Crash” (see more below) clients have asked if investing is rigged in favor of a handful of insider investors. Even if you didn’t see the60 Minutes segment about Michael Lewis’ newest book, “Flash Boys,” or read the article in the March 31NY Times Magazine, you have probably heard the reverberations about High Frequency Trading (HFT) firms and the concerns and hand wringing about the deck being stacked against the average investor.
It is important to understand that HFT has been part of the investment landscape since 1999, with the 1998 SEC authorization of electronic exchanges. At the outset, HFT trades had an execution time of several seconds. But today, sophisticated technology tools combined with computer algorithms have reduced the time to milli- or microseconds.
It is less expensive to trade stocks now than ever and those prices can only come down further. One of the reasons for reduced trading prices is the speeding up of markets via HFT and algorithmic trading. As many of you recall, it was less than a generation ago that prices were only available on delay and were quoted via telephone. Now companies are offering free trades and one-second execution guarantees. Free real-time pricing is available to anyone with a computer and internet access.
Unlike long-term investors, High Frequency Traders move in and out of short-term positions to capture just a tiny fraction of a cent in profit on every trade. HFTs typically compete against other HFTs, rather than long-term investors, and it has become increasingly difficult to deploy the HFT strategy profitably. HFT is a low margin game requiring incredibly high trading volumes, often in the millions, to generate a profit. In fact, HFT profits have been on the decline. In 2012, HFT profits were estimated at about $1.25 billion, down significantly from their estimated 2009 peak of $5 billion.
The concerns raised by politicians, regulators, economic scholars, journalists and market participants have led to discussions on whether and how HFT should be subject to regulation. HFT has been the subject of intense focus and debate since the May 6, 2010 “Flash Crash,” when a $4.1 billion trade on the NYSE, disrupted HFT algorithms and resulted in a loss to the Dow Jones Industrial Average of over 1,000 points (which was recovered within about 15 minutes.)
Many economists and market pundits, as well as several studies, have reported that HFT provides market liquidity, reduces volatility, lowers transaction costs for retail investors without impacting long-term investors, and does not pose a market system risk. Inarguably, there are costs built into the system that seem “unfair,” including the advantage HFT firms have in providing the markets with liquidity. But every market of any kind anywhere in the world has information asymmetries and first-mover advantages, and at a certain point it becomes impossible to legislate away costs. Asset managers, pension funds and hedge funds have an incentive to reduce transaction costs. Let them follow that incentive. They are well aware that a new technology may come along and disrupt their paradigm.