With the furor over HFT (High Frequency Trading) reaching critical mass in the wake of Michael Lewis’ book Flash Boys, considering the implications of the controversy surrounding HFT is an exercise well worth conducting. In November of last year at Charles Schwab’s Impact Conference I witnessed the Steve Kroft interview of Michael Lewis that was recently featured on 60 Minutes. I remember thinking at the time that this wasn’t an issue of interest only to a narrow subset of traders, but rather something that deserved the attention of anyone taking part in the capital markets, whether on Wall Street or on Main Street.
Technology Outpaces Regulation
A core takeaway from Lewis’ book is that modern-day technological advances in the form of HFT have, to some degree, outstripped the ability of regulators to police markets and keep them fair for all participants. By taking advantage of super-fast computers and location arbitrage (enabled by lighting-fast connections and the ability to co-locate computers at an exchange), HFT traders have been able to, among other things, front-run the orders of market participants with slower connections, thereby gaining what appears to be an unfair advantage based on technology rather than any superior understanding of market conditions or trends (factors traditionally utilized to enhance investment returns).
If you know what other market participants are going to do before they do it that is a valuable piece of information, and insights of this type appear to have been used by certain HFT shops to realize large gains by repeatedly booking profits in small increments with little or no risk of loss.
The Regulatory Reaction
The hubbub created by Flash Boys has increased the pressure on market regulators and law enforcement officials already investigating HFT practices, including the SEC, FBI, and New York’s Attorney General, to deal with the issues cited in the book. The outcry over the unfairness involved in some HFT techniques now seems likely to lead to reform of the electronic trading systems underlying today’s markets in an effort to rectify the issues raised in Lewis’ book. While the practices exposed in Flash Boys may not have caused great injury to any particular investor, the ability of HFT shops to make very small amounts of money consistently by getting in front of the trades of other investors allowed them to amass billions of dollars in profits at the collective expense of investors lacking the ability to take advantage of such techniques.
What it Means for Investors
The existence of HFT hasn’t changed the value of focusing on long term wealth creation via the capital markets. Investors who have the discipline to ride out the volatility that comes with investments in these markets shouldn’t let the existence of HFT impinge on their wealth creation strategies. That being said, if regulatory efforts in the wake of Lewis’ book are successful in reining in the excesses of HFT it will be a significant victory for market transparency, as well as serving to bolster investor confidence in the fairness of the capital markets.