High-frequency trading (HFT) is in the news a lot lately, what with the publication of Flash Boys, essentially an indictment of the industry, and recent scandals involving HFTs and dark pools. In our second installment, we'll investigate the costs and benefits of HFTs.
First of All: Who's the Winner?
Academic research supports the idea that HFTs have, as noted last time, improved liquidity in markets and reduced bid-ask spreads (i.e., lowered transaction costs). They've made prices more accurate, reduced the "noise" in pricing data, and made trade execution faster.
All of this implies that anyone who buys or sells stock -- and who is not a trader (this is important later) -- wins. And indeed, that does seem to be the case. You, as an individual, can buy and sell equities faster, cheaper, and more accurately than ever.
Even people who buy through third parties are better off because of these improvements in market efficiency. The head of Vanguard's global equity index group testified before a Congress hearing on HFT that "individual investors who access the equity markets through asset managers like Vanguard have, without question, benefited from the market structure improvements that have been made over the last twenty years."
How did these changes benefit you? Because you're not going in and out of stocks based on transient changes in the information environment. You're buying and selling shares to invest, based on fundamental analysis rather than trends. If you were a day trader trying to make money through technical analysis, I'd probably feel bad for you -- you will almost certainly never be as fast or as accurate as an HFT.
Which Brings us to the Losers
There's almost always a loser when new competition enters a marketplace, and in this case the primary losers are institutional traders and market makers.
To get an understanding of this, pretend you're Carl Icahn. Every time you take a position, the market moves, so if an HFT gets whiff of what you're doing prices could very well change quite drastically. And HFTs are really, really good at figuring out what you're doing.
Thus, it doesn't seem coincidental that the phenomenal growth of dark pools, which are off-exchange trading venues that strictly protect anonymity, has mirrored the rising prevalence of HFTs. Considering the average size of a dark pool trade (187 shares) one does get the sense that certain market participants are trying to get any sort of cover they can from the watchful gaze of HFTs.
None of this is to say that HFT side-deals with dark pools to secretly access private information are OK. It just shows you who HFTs are competing with -- not you and me, but big institutional traders whose decisions have the ability to move markets.
You could argue that traditional market-makers also lose. As far as I know, there's no way to compete with HFTs without resorting to similar tactics, namely quantitative analysis and more rapid information processing.
So Why Do They Make So Much Money?
As I mentioned last time, revenues in the HFT space are falling as efficiency improves. But some people look at the industry's enormous investments in fiber-optics (really fast) or microwave (even faster!), which can improve speed by mere fractions of a second, and think, no this can't be right.
And it does seem a little bit ridiculous to the lay observer. But I'd also argue that the revenues from fees are not threatening to the market as a whole. Market making has, historically, been a profit-generating activity, and improving its speed and accuracy will only make it more so.
I'd also point out that gains from directional bets is coming at the expense of other traders, not us. In other words, if HFTs want to take trading market share away from the Goldmans of the world, I don't see why they shouldn't be able to.
Now of course, there are two caveats to this. First of all, none of this excuses the glaring conflicts of interest and questionable tactics mentioned in Part One of this series. These are serious issues that need to be addressed and rectified -- gaining advantage through insider status or unfairness isn't part of what makes competition good.
The second question, which a lot of people are asking themselves, is whether the industry's fixation on trading is beneficial for anyone. Is it good for the economy? For science, society, and innovation?
That, to me, is part of a larger discussion about the financial industry's place in society as a whole -- a subject that is completely engrossing, but far to sprawling for this humble primer.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.