HIGH-FREQUENCY TRADING

A more complex and less well-known situation is the high frequency stock trading (HFT) described by Michael Lewis in the 2014 book Flash Boys. Lewis describes a profitable market activity made possible by the acquisition of information slightly earlier than one’s competitors (where earlier is measured in microseconds). By trading quickly and frequently on this advance market info, HFT firms were able to earn upwards of $7 billion annually at its peak in 2009 while never actually holding onto any stock positions even overnight. In other words, these firms never actually invested their money, but rather stepped in between other traders as intermediaries, making very small profits on each trade.

Intermediaries can often provide a valuable service as when they facilitate the matching of buyers and sellers more cheaply than the participants themselves can achieve. Indeed, this is the argument that HFT firms use when they argue that their activity boosts market “liquidity.” Perhaps, some of what HFT firms do conforms to this example. However, a less charitable interpretation is offered by Lewis.

Rather than providing a valuable service, HFT firms were engaging in a kind of “electronic stock front-running” scheme that makes their activity tantamount to sophisticated, albeit legal, theft. By stepping in front of a trade that would have occurred regardless of their presence, HFT firms imposed a small transaction cost on other trading firms that went virtually unnoticed until it began to be recognized by the protagonists in Lewis’ book, among others.

A clear indication that these “services” were undesired is that substantial efforts have subsequently been made to protect trading firms from the losses imposed on them by HFT schemes (see the Brad Katsuyama video on the right). The impact of these protection efforts has been the reduction in HFT profits to only $1 billion as of 2017. This case provides another example of greed in the financial sector. HFT firms’ pursuit of self-interest was unfettered, arguably, because it did not improve economic efficiency but instead forced other businesses to devote resources to protect themselves from the so-called “liquidity services” of HFT firms. It is a case of a group of companies NOT following the rules of capitalism.

Steven Suranovic, December 1, 2019

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