04 Apr 2014 Flash in the Pan?

The latest flap about high frequency trading has everyone talking again about fairness of markets, with some, namely Michael Lewis, calling them ‘rigged.’ In essence, it’s a story about a few trading on information obtained before the public gets the same information. Not surprisingly, the concept is not new.

In 1815 Nathan Mayer Rothschild, through his network of carrier pigeons, learned before everyone else that Britain and Prussia had defeated Napoleon’s army at the Battle of Waterloo. With the knowledge that his country was not about to be overrun by the French, he bought as many British government bonds as he could get his hands on and made a fortune when the news of Warterloo became public.

Information has always meant power or profit – he who gets it first wins or profits. Faster horses, chariots, sailing vessels, signalling systems, radios, telegraphs, and telephones meant victory and profit. But this debate is about more than speed of information. The debate over high frequency traders HFTs centers around fairness and public trust; or more specifically whether HFT is insider trading, therefore illegal, or worse, threatens the long-term integrity of our markets.

How it works 

HFTs put computer servers close to exchanges, reducing travel time for orders from computers to the exchanges’ electronic matching engines. They also speed the technology ‘pipes’ using fiber-optic cables, microwave towers, and lasers to trade faster between geographically diverse markets. And most significant and complicated, HFTs pay exchanges for proprietary data feeds. These feeds are different from the public, consolidated data feed maintained by the public exchanges, called the securities information processor, or the SIP (think of the tickers crawling across the bottom of your TV or browser screen). The SIP is meant to ensure that everyone gets the same price information at the same time.

But the exchanges also sell what are known as proprietary market feeds to most anyone who pays for them (we have one that tells us every buyer and seller interested in a security at any given moment). According to Businessweek, “by law, prices must be entered into the SIP and the proprietary feeds at the same time, but once the data leaves the exchanges, the proprietary systems often process and transmit the information faster. These feeds arrive sooner and contain more robust information—including all prices being offered, not just the best ones.”

As you can see, the question has become a technological one, stretching the bounds of the classical definition of insider trading; ‘having access to material, non-public information before it reaches the rest of the market.’ The regulated exchanges send the information at the same time, but once they have transmitted it (the matter of their control the question) those with the best networks get it the first. So where does a technological advantage become an illegal informational one?

In a Bloomberg BusinessWeek article entitled What Michael Lewis Gets Wrong About High-Frequency Trading Matthew Phillips makes some good points that HFTs don’t prey on small mom and pop investors. He says “Speed traders aren’t competing against the ETrade guy, they’re competing with each other to fill the ETrade guy’s order. While Lewis does an admirable job in the book of burrowing into the ridiculously complicated system of how orders get routed, he misses badly by making this assumption.”

He also points out that speed trading is not hugely profitable. The spreads between bid and ask prices, due to the influence of HFTs is down from $.12 to $.01 these days. Lower cost for trading is a good thing. Finally Phillips in his article points out that HFTs are not Wall Street insiders. In Flash Boys it’s a group of former traders at Royal Bank of Canada who go on to form their own exchange. He goes on to say “many HFT ventures are the consummate outsiders like Tower, Hudson River Trading, and ATD, all started by tech geeks who figured out a better, more efficient way to trade. Their first victims weren’t mom-and-pop traders but big, established, market-making firms that made up the clubby insiders’ group of floor specialists.”

Why as a Beacon Client You Need Not Worry

We are investors, trading (buying or selling securities) only infrequently to rebalance or accommodate our clients’ cash flows. We own and trade three huge and highly liquid Exchange Traded Funds ETFs (with very large trading volumes throughout the day – leaving little to no chance of manipulation).

To borrow from an analogy of Benjamin Graham, the father of modern investing, the market in the short-term is a voting machine and in the long-term a weighing machine. ‘Voters’ should be worried about pennies and fractions of pennies going to HFTs, because those few cents can often be the difference between profits and losses. Day-traders, buyers of ETFs focused on esoteric schemes or segments of the market, and high-turnover mutual funds should be concerned about HFTs and others who are able to potentially siphon pennies from their profits. The regulators will struggle to protect this class of market participants.

But as investors, we need not be greatly concerned. We measure our investment horizons in periods longer than milliseconds and gains in more than pennies. We have substantial and unshakable fundamentals on our side. We invest with the confidence that thousands of intelligent men and women collectively the world over, profit by making reasoned and sound decisions, leading their companies to create better things that we need, want, and that make the world better.

Corporate leaders and long-term investors are the ultimate winners of Waterloo, not the Rothschilds. As news their triumphs flash across screens and voters trade their guesses about the merits, billions of dollars change hands instantly, but with little or no real consequence. It takes time and customers to weigh the merits of new creations. On the whole, profits flow from a continually improving stream of creative products and services that add to our wealth, and that of nations. Flashes in the pan are mere distractions, perhaps entertainment. Let the regulators worry, you don’t need to.