General Motors’ recent problem with ignition switches and the inept manner in which the firm handled it have left a black mark on the entire auto industry. There’s certainly plenty of room for improvement. But no one is talking about banning cars because of it. The same goes for the stock market and issues raised by high frequency trading, or HFT.
Michael Lewis’ new book Flash Boys: A Wall Street Revolt, released last week alongside a 60 Minutes television investigation into the story, has generated substantial concerns about the impact of HFT on North American stock markets. Lewis provocatively claims “the stock market is rigged” due to the ability of certain traders to complete transactions faster than others.
It may be true, as Lewis’ book argues, that Canadian banker Brad Katsuyama uncovered and put a stop to the ability of some traders to use miniscule speed advantages to occasionally front-run other traders’ orders: that is, buying ahead of an incoming order. Katsuyama figured the solution to this issue was to set up his own stock exchange designed to reduce any speed differentials between traders.
As significant as Katsuyama’s insight may be, it is important to stress that there’s no definitive evidence proving North America’s stock markets are “rigged.” Analysis of large volumes of market data makes it clear to me our stock exchanges are among the world’s fairest and most efficient. Further, whatever a publicity-seeking author or television program may claim, HFT is not evil. Numerous impartial studies have conclusively shown high-speed traders deliver a net benefit to all investors: from Wall Street and Bay Street right down to the smallest retail investors with an RRSP.
Liquidity is the life blood of any market, and the presence of high frequency traders buying and selling massive volumes of stock in the blink of an eye inevitably makes markets more liquid. This means when HFT goes up, trading costs go down. Research also shows HFT makes markets more efficient by pushing stock prices in the right direction, allowing investors to buy and sell assets at correct valuations.
And while the famous May 6, 2010 Flash Crash—during which investors lost (and quickly regained) hundreds of billions of dollars—is often blamed on the shenanigans of computer jockeys and their algorithms, data-driven evidence is much more ambiguous.
My own research finds that large price swings are not the sole handiwork of HFT. On the contrary, these traders typically work to counter such swings. And remember, “flash crash” scenarios have played out numerous times in the past. The crashes of 1962 and 1987, for instance, occurred without any help from HFT.
Summarizing the sizeable body of research on this topic: the presence of what Lewis calls “Flash Boys” has generally improved liquidity, narrowed spreads, and made our markets more efficient.
That said, there will always be room for improvement, as the experience of Katsuyama suggests. Whenever large sums of money are in play, investors and regulators must be vigilant. For example, a recent study by my research team shows that a 2011 trading rule curtailing naked access—or the ability of high-frequency and other traders to submit orders without the oversight of brokers—has significantly improved liquidity in the U.S. This suggests the system can be tweaked to make it fairer and more efficient without disrupting the benefits brought about by modern technology.
It is also important to understand that the presence of HFT and its role in providing liquidity will inevitably change the behavior of public companies. For example, new studies find computer algorithms prefer lower priced stocks, largely because these stocks offer a better return per dollar invested. As such, public companies should be aware of how their stock price affects liquidity; some should consider splitting to lower prices.
As with any disruptive innovation, high-frequency trading will need fine-tuning and regular oversight. But claims it has completely “rigged the market” are uninformed and unfounded.
Andriy Shkilko teaches at the School of Business and Economics at Wilfrid Laurier University. He holds the Canada Research Chair in Financial Markets. Follow him at @AndriyShkilko.