My Take on High Frequency Trading

Just in case you haven’t watched the financial news lately, everyone is up in arms about High Frequency Trading.  HFT is employed by financial firms with superfast computers, who can execute stock trades much faster than retail investors.  With sophisticated HFT algorithms, they can predict orders and then buy and resell shares to the retail investor at a markup.  Some people call this Front-Running and others call it a Skim.  Either way, I call it ripping off investors.

The Cat is Finally out of the Bag

Flash Boys

Flash Boys by Michael Lewis

I have been warning my readers about superfast trading since August of 2011 and again in December of 2011.  But, nobody listens to a small-time blogger like me.

The book Flash Boys by Michael Lewis has created a big controversy this week and is currently the #1 Best Seller on Amazon.  Lewis exposes the unfair practice of HFT and the firms who are preying on investors.  He has been on a whirl wind media tour promoting the book and this has been a catalyst for many to finally call for an end to HFT.  Even Jim Cramer, an unapologetic Wall Street insider, devoted a whole section of his show to rail against it.

Predictably, the financial firms profiting from HFT have viciously attacked Michael Lewis on TV and in the media.  They are making easy millions and are not going to let a rogue author derail their gravy train.  But, the cat is out of the bag and there is no conscionable way to defend HFT.  In the past few days, I have heard and read all kinds of arguments to defend HFT, but how can they justify the outright skimming of investor’s trades?  They can’t.  These arguments are a merely a distraction from the real issues of an unfair playing field and the exploitation of investors.

Why You Should Care

You may be wondering why should you care?  Maybe, you don’t even invest in stocks.  You should care because your 401K, pension and mutual funds do and you are getting ripped off indirectly.  As if the fees and MERs aren’t high enough, now there is a level of pure parasites, siphoning off your profits.  Unlike the fund and 401K companies, they don’t create, manage or add value to your investments.  They just take a cut from the transactions, because they can.  Everyone has known about High Frequency Trading for years, but no one has lifted a finger to stop it.

Around 50% of all recent trades are HFT, so this is a very large problem.  With this type of volume, there is a very real potential for future Flash Crashes and other volatility problems.  A rogue algorithm could create all kinds of problems for the markets.  At the very least, it may discourage investors from investing in the stock market, because they perceive it is rigged.  In my opinion, it is rigged.

What Happens Next?

The Attorney General of the U.S. announced the Justice Department is investigating HFT to see if it violates insider trading laws.  The F.B.I. also announced an investigation and so has the SEC.  It appears as though Michael Lewis, his book and his interview on 60 Minutes have finally shamed regulators into action.  The real question is how will this all play out?

I don’t believe anyone will get arrested or go to jail.  HFT executives will likely be hauled in front of Congress, because it makes for good theater and we all know how Congress looks out for us on Main Street.  The big investment banks and others on Wall Street have already distanced themselves from HFT.  The HFT firms will likely be out of business soon and that’s a blessing for every investor.

The Bottom Line

The bottom line is that it’s one thing to have faster access to a trading network and quite another to be able to see, markup and resell a security, based on someone else’s order.  If you aren’t outraged by this outright theft of your hard-earned investment deposits, you definitely should be.

“High-frequency trading is a growing cancer that needs to be addressed.”

Walt Bettinger – President and CEO, Charles Schwab

Recommended Reading

Money Counselor – High-Frequency Trading
Wall Street Journal – Fallout from HFT Hits Brokerages
USA Today – Justice Department Looks into HFT

11 comments to My Take on High Frequency Trading

  • As you know Bret, we’re on the same wavelength here. I agree, there is no conscionable defense for HFT. In my opinion the regulators and Justice people have ignored it because they perceive a PR difference between a billion people getting ripped off for 1 cent each vs. 100 people getting ripped off for a million dollars each. That’s the real genius behind HFT–individual investors don’t perceive much impact on them personally, so no political consequence of ignoring this particular crime.
    Kurt @ Money Counselor recently posted..Motif InvestingMy Profile

    • Kurt,

      We are definitely on the same wavelength. I wrote my article before I read yours and they were pretty similar in our predictions.

      I agree the small amounts per transaction allowed HFT shops to fly under the radar, while making billions from investors. I’ll be really glad when they finally put a stop to it.
      Bret recently posted..Why You Need a Financial PlanMy Profile

  • I’m surprised more people aren’t talking about this issue. It sounds like there is good reason for all of us to be interested! Thanks for helping us learn more!

  • Kyle

    I’ve noticed that one of the common defenses of HFT is creating liquidity and efficiency in the market that couldn’t exist otherwise. An article I read by Matthew O’Brien called “Everything You Need To Know About High Frequency Trading” mentions index tracking funds that are identical in minute intervals, but deviate from one another when examined on a smaller scale. Proponents suggest that only HFT could close a 20 millisecond price gap.

    It seems to me, though, that HFT is not making the market, rather it is stealing a piece off a deal between a buyer and seller that would have found each other anyway. Even if we do accept that HFT helps prices to agree in a time frame that makes a blink seem protracted, does that really benefit anyone but a flash trader? It certainly can’t outweigh the costs to investors… Can it?

    • Thanks for stopping by Kyle.

      I’ve heard the liquidity argument by virtually all of the HFT execs over the past week. But, here is the reality of the markets. The liquidity only exists in a demand market, but evaporates in a millisecond during a panic, so the HFT traders won’t lose money. That is exactly what happened during the Flash Crash. So, the liquidity isn’t there when it’s really needed to calm the markets.

      I also don’t see how they can claim to create any liquidity or efficiency, when they are just front-running trades that would have executed without them anyway. I do believe HFT adds costs, without any benefit to investors. One of the biggest examples is the added cost to index funds, who are forced to rebalance frequently.
      Bret recently posted..You are Wealthier than you ThinkMy Profile

  • TCI

    I have heard about this super computers before and I agree with you 100% that they shouldn’t be allow. Think of a scenario. When the prices start shooting up, they will contribute to the upward trend by buying before everyone else thereby creating a false price. They wouldn’t care and get burnt from it because they would offload those stocks before the prices start correcting. It is a good point that even we are not dealing with stocks we would lose out when they are filling their pockets.
    TCI recently posted..Pay Off Old Auto Loan and Bring Insurance Premium DownMy Profile

  • Just read the Michael Lewis book over the weekend. Good stuff as usualy. Nice, crisp and succinct to get to the point. A great story teller as there ever was.

    Now just waiting for the regulators to wake up and make sure that the markets are equal for all participants.
    DowJonesToday recently posted..High Return FX Trade – Short Japanese Yen ETFMy Profile

    • Yeah, the regulators seemed like they were all over it when the book was released, but now they are suddenly silent. It’s almost like someone got paid off and it’s back to business as usual. This is one of the most obvious and unfair market manipulations I’ve seen. It can’t be allowed to stand while the government tries to assure everyone the markets are fair.

      I am hoping regulators are quietly building a case and someone actually goes to jail this time. I’m not holding my breath, but I’m definitely hoping.
      Bret recently posted..Life is Getting a Lot More ExpensiveMy Profile

  • […] Hope to Prosper, Bret review the new Michael Lewis book on High Frequency Trading.  We’ll have something eventually, but I must admit not having read it […]