Unless you live under a rock, you now know that HFT stands for High Frequency Trading. Michael Lewis’ new book Flash Boys: A Wall Street Revolt can be loosely summarized as “HFT is evil.” He describes, for example, how some traders systematically exploit the milliseconds of difference in the time it takes signals to reach different stock exchanges in order to jump in ahead and buy stocks then turn around and sell them at a higher price fractions of a second later. Others have spoken in defense of HFT. In a Financial Analysts’ Journal article earlier this year, Cliff Asness provided a neat summary of the case for “HFT is good”: “it smashed the old dealer and exchange cartel (providing a much lower barrier to entry for competing market makers), democratized flow information, and replaced very expensive humans trading a handful of securities with very cheap machines trading a great many”.
My personal take on all this is that, even though CNBC may benefit from aligning people into sides yelling “good” and “evil” at each other, that is really just a distraction from the real issue here. Turning HFT into a story of good vs. evil is a smokescreen.
I say that because HFT – which represents more than 50% of trading on U.S. stock markets¹ – is not one or two trading practices but thousands. It’s what makes markets today. On the other hand, some of those trading practices do act against investors’ best interests.
But you don’t need to jump into a camp of “good” or “evil” and you don’t even need to reduce it to an argument about whether “net-net” HFT brings benefits or not. It’s perfectly possible to believe that there could be room for selective regulatory action around certain practices without throwing out the whole thing. You can accept that HFT is (as Cliff puts it) “how modern market-making in a technologically advanced world is done, and there is no going back” without concluding that it would be wrong to change anything about it.
The real challenge may lie in working out what steps can be taken that would do more good than harm. As Flash Boys points out, much of the activity it criticizes is only possible because of an apparently very reasonable rule called Reg NMS that requires brokers and exchanges to find the best market prices for their clients. It turns out that the steps brokers take to ensure they do this are what tips off the HFT community that activity is pending. Unintended consequences. So effective regulation around the undesirable HFT practices may not be simple.
But the bottom line is that this is not about good or evil and even the “net-net” doesn’t really matter: if something can be done about the undesirable aspects of HFT activity without damaging markets in other ways, it should be.