April 08, 2014

I'm pretty tired of hearing about HFT. It's like a Sunday morning talk show. We know the Democrats and Republicans never see eye to eye. That's why I don't watch the Sunday morning news programs. They're too predictable.

The same thing is true when it comes to high frequency trading. The debate is predictable and boring. Proponents claim HFT provides lower trading costs and liquidity to investors. The anti-HFT crowd points to electronic front running, mini flash crashes, complex fee structures and other market structure problems that are caused by HFT. We've heard it all before. The two will never see eye to eye. Each side will trot out market data and "studies" that supports their argument.

In short, the current debate surrounding Michael Lewis' "Flash Boys" and his media blitz to promote his book has nothing to do with HFT. It really has to do with an incomprehensible market structure that has developed post Reg NMS. Thirteen exchanges, 40+ dark pools and maybe 200 brokerage internalizers make it all but impossible to make sense of the markets (even for 'sophisticated' investors). The current U.S. market structure that Lewis claims is rigged is 100% legal and complies with all regulations, but is unnecessarily complex and likely harmful to the markets.

I've waited to weigh in on the "Flash Boys" debate until I finished the book, had some time to reflect on it and also speak to a few people in the industry. Truth be told, I think Flash Boys is poorly written. Lewis is generally a very good storyteller, but I think Flash Boys falls short. Lewis chose to ignore many facts and arguments about current market structure. Why? Was he under a page count limit? The book seems rushed and incomplete. If the "HFT provides liquidity" arguments are hogwash, spend a chapter on it and explain to the readers why. We all ponied up $20 to read the book and we'll sit through another chapter if it helps clarify the debate.

The real meat of the book centers on the problems Brad Katsuyama and his band of unlikely heroes at IEX has found in the marketplace. Truth be told, others have been talking about these marketplace inequalities for a number of years, including Joe Saluzzi and Sal Arnuk at Themis Trading and Eric Hunsader at Nanex. Larry Tabb, founder of Tabb Group, also points out the complexity of the markets in a recent column and argues that the markets are not rigged (as Lewis contends). The market structure is complex ... far too complex ... for investors. Having order types that are designed just to sniff out an investor's intent seems crazy, especially when these order types are also designed to never be filled. Lewis took particular aim at the various order types.

The increased usage of dark pools and internalizers is also a big problem. No one really knows what happens to an order while it is in a dark market. According to Reuters, almost 40 percent of all U.S. stock trades now happen somewhere other than the 13 exchanges, up from around 16 percent a few ago.

As an individual investor, I'm not really concerned with losing a few pennies on the five or so trades I make each year. My orders are pretty small, 100 or 200 or maybe even 300 shares. So, yes, I might be getting scalped for a dollar or two by HFT players, but I'm not going to call for a complete rewrite of regulations over a few bucks. There are plenty of other inequities in the world that I should be spending my time worrying about.

But as someone who has a 401(k) filled with mutual funds, I am concerned. If some of the estimates are to be believed, a large mutual fund provider loses millions a year just because of market complexity. In Flash Boys, the president of a $9 billion hedge fund estimated he was losing $300 million a year because of the current market structure. Fidelity Investments has $1.7 trillion under management in its mutual funds alone. Do the math. That gets me pretty angry. Many of the losses that are absorbed by investors come from the ability for some trading shops too take advantage of latency arbitrage, or order type arbitrage, or other techniques that, to my somewhat educated eye, provide no value to investors. I might be wrong, and if I am, I hope someone can enlighten me as to how these various methods help make the markets more liquid and a better place to raise capital.

In the end, I think Katsuyama summed up why this debate is really about market structure and not HFT. In Flash Boys, Katsuyama says:

This is not their fault. I think most of them have just rationalized that the market is creating the inefficiencies and they are just capitalizing on them. Really, it’s brilliant what they have done within the bounds of the regulation. They are much less of a villain than I thought. The system has let down the investor.”
Greg MacSweeney is editorial director of InformationWeek Financial Services, whose brands include Wall Street & Technology, Bank Systems & Technology, Advanced Trading, and Insurance & Technology.