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Is High Frequency Trading Unfair? And Other Questions We Need to Ask

on April 4 | in Finance, Technology | by | with No Comments

Last Sunday, best-selling author Michael Lewis appeared on CBS’ 60 Minutes to talk about his new book, Flash Boys, which focuses on high frequency trading in the U.S. stock market. He stated that firms using high frequency technology (HFT) have an unfair advantage over all other investors. “The United States stock market, the most iconic market in global capitalism, is rigged,” said Lewis.

While recent media coverage is elevating the topic of high frequency trading and the advantages or disadvantages it presents, the issue itself is not new to the market. James J. Angel, financial markets expert and associate professor at the McDonough School of Business, explains:

People have been racing in financial markets since the beginning of time. In old days, traders would pay extra to rent brokerage space right next to the exchange so runners could get to the exchange faster. Now, they pay extra to have their computer server located in the stock exchange data center so that their orders get to the exchange faster. So, to a certain extent, none of this is new in the history of markets. The technology is different, but the games are the same. They’re just being played on a faster scale.same game quote-01

Perhaps the question shouldn’t just be whether or not HFT is good or bad; but rather, what does HFT mean for the market itself? Angel believes some of its greatest implications lie in regulations.

“A high-speed computer is just a tool,” he explains. “We still need to make use of productivity-enhancing tools, but at the same time, we need to have regulators who understand how to discern between who is using the tools to do good to help the market and who is using them to do bad things to manipulate the market.”

Angel offers the following steps as ways to improve regulation of the market:

Provide the SEC with the resources to hire good people and the tools to do the job.

“Unfortunately, we’ve always underfunded the SEC. If you look at the SEC budget from the beginning of time and scale it up into current dollars, it comes in around $20 billion. This is less than investors lost in one ‘Bernie Madoff’ crisis.”

Upgrade the skillset of the SEC.

“We need to monitor how the SEC uses their resources – to ensure they hire the right people who have an understanding of market technology and engineering or technology skills.

Move the SEC to New York City.

“I love Washington, D.C. But, if you want to hire people who understand how the markets work, then you go to where the markets are located.”

Even if regulation improves, is the retail investor disadvantaged by this increasingly technology-driven market?

Paranoia Quote-01

“I don’t think so,” says Angel. “By all the traditional measures of market quality, retail investors are better off than they’ve ever been before. Commissions are lower, visibility is higher, transaction costs are lower, and there is really no way to show that the retail investors are any worse off. The market is certainly not perfect but we must remember that our markets are different now. Their imperfections are a different set of imperfections than in the days of old.”

Angel also advises not to let the high frequency trading debate cause panic, especially if you are a low frequency investor. You need to be more paranoid about your financial advisor than about the stock market,” he says. “The guys to whom that millionth of a second advantage matters are mostly racing with each other.”

James J. Angel is an Associate Professor at Georgetown University’s McDonough School of Business. He specializes in the structure and regulation of financial markets around the world, has visited over 50 financial exchanges globally, and has testified before Congress on issues relating to the design of financial markets. His current research focuses on short selling and regulation. Follow him on twitter @GUFinProf

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