Which is better, to go with the ever faster flow and embrace flash trading – or reign it in?
Two opposing views.
Oliver Stock Embraces Speed
Ever since the invention of money, we have been trying to distribute it in an equitable manner that unfortunately, has too often gone fundamentally wrong. One of the few effective instruments for the distribution of money is the stock market. The more smoothly markets run, the more money is brought into circulation and the better it’s distributed.
The corollary is that the quicker traders can react, the better stock markets run, which is why the much-vilified practice of high-frequency trading on markets is actually a good thing.
Need proof? High-frequency trading has led to a significant drop in the costs for every order. Ten years ago, I would have paid almost €70 ($89) when I wanted to buy €25,000 in stocks on the DAX index of the German stock market in Frankfurt. Today, thanks to computer-controlled high-frequency trading, the cost is just €12.
It used to be that traders could get rich through trading thanks to arbitrage, which is the exploitation of price differences. It was a seductive game, but it was like a traffic jam on the freeway: nothing is moving in the left lane, but there’s creeping movement on the right lanes as drivers are darting from lane to lane in an effort to get where they’re going faster. Just as the chances for a huge crash are increased by that kind of freeway traffic, there was always the chance of a mishap in the trading arena.
High-frequency trading reduces this danger because it reduces arbitrage profits. When trading is faster, prices align faster.
To me, those seeking to ban high-frequency trading are like people who prefer traveling by stagecoach instead of on freeways. Should we go back in time because there might be a catastrophic pile up? That won’t work. What we need are rules. We must stop the reckless speedster, not the focused but fast driver.
Computers are often used for high-frequency trading because machines react more quickly than people. They remain on the lookout for price differences for the same stock on different markets and assure that those prices are quickly brought into alignment. Computers are enormously important to a functioning market. We must continue to pave the way for them.
Some high-frequency traders are merely racing to snap securities away from others – thanks to faster connections – and to offer them back at a higher price. These gamblers call themselves “frontrunners” because they exploit the technological advantage of having better connections and faster processors. But instead of putting the brakes on these faster computers, wouldn’t it be more realistic to upgrade the slower ones?
This brings us to the core of the problem. Markets must provide an even playing field. There shouldn’t be a privileged few high-frequency traders pitted against investors who have no chance of keeping pace.
What is needed is a common high-speed connection and effective market regulation. In the United States, where markets and options are traditionally more popular than in Germany, the IEX stock exchange has been founded on two principles: everyone trades at the same rate and for the same price.
So far, no crashes have been reported there.
Michael Maisch Says Slow Down
Do you still remember May 6, 2010?
On that day, our unconditional belief in the progress of the financial industry – our faith that every effort to go faster, higher and farther would usher in an era of more efficiency and greater prosperity – was lost once and for all.
That day on Wall Street, the Dow Jones Industrial Average suddenly dropped by almost 1,000 points and the huge number of transactions caused a dramatic collapse in the market values of many companies. Utter chaos reigned.
The search for those responsible for the “flash crash” led to dealers using computers or, to be more precise, to a small group whose influence has grown from year to year: high-frequency traders. Using sophisticated algorithms, they bombard stock markets with a flood of orders in microseconds in their efforts to be faster than anyone else, gaining access to selling and buying quotations, and converting their edge into lucrative business deals.
High-frequency firms pay enormous sums and compete for the chance to set up their supercomputers directly alongside stock market computers. The time it takes for an electric impulse to travel through the cables can be the difference between profit and loss. In the United States, more than half of all orders now originate from high-frequency traders.
Since the flash crash, regulators have been driven by fears that the sheer mass of computer orders could trigger market price tsunamis. But flash traders have always been controversial and many professional investors feel they are simply at a disadvantage due to the high-tech competition. The criticism has taken on a new aspect in recent months.
In the United States, concerns over high-frequency trading have attracted the attention of the Senate, while prosecutors are investigating allegations that some practices by flash traders may constitute insider trading.
There are believers in progress who say flash trading provides more liquidity and, therefore, a more efficient stock market. Yet this argument doesn’t hold up because flash traders can withdraw orders just as quickly as they place them. Their liquidity, to a large degree, is an illusion.
If you give the speed demons full reign, market trading threatens to degenerate into a ruinous technological arms race. Even worse, high-speed traders endanger the integrity of the markets and the stability of the entire financial system.
What’s interesting about discussions of high-speed trading is that criticism is coming not only from regulators and politicians, but also from the financial industry itself.
A few days ago, the best-selling American author Michael Lewis was awarded the German Economic Book Prize for his work “Flash Boys,” which takes a critical look at high-frequency trading. While there are many scoundrels in the book, there is also a hero playing the lead role, Brad Katsuyama, who wants to decelerate trade and make it fairer through a new stock market. Among supporters of the project are hedge fund manager David Einhorn and the investment bank Goldman Sachs, neither of which are regarded as sensitive souls.
If even tough-as-nails financial professionals believe we have a problem with high-speed trading, we probably do.
Oliver Stock is editor-in-chief of Handelsblatt Online. Michael Maisch is the deputy editor of Handelsblatt’s finance section. The contact the authors: email@example.com and firstname.lastname@example.org.