What Michael Lewis is Not Telling You About High-Frequency Traders

Apr 2 2014, 4:34pm CDT | by

Michel Lewis has a brilliant ability to touch people’s nerves. It’s pretty amazing that he single-handedly has made high-frequency traders (HFTs) more hated than banks. Yet, before we declare Lewis to be the new moral authority for all things investing, note that he may himself riding on the coattails of HFTs in his own investments, although he may not even know it.

First, let’s get one thing straight: we agree with Lewis when he says predators rig markets. However, last time I checked, it was greed, not love that makes a market. The market is not a friend you “like” on your favorite social media platform. No, the market is everyone else trying to make money off you. So while Lewis clearly touched a raw nerve, as investors are frustrated, is it really news that the markets exert frustration on investors?

When you place an order on an exchange for 100 shares you might be able to get “best execution.” But if you place a larger order you better “work” that order. Why would someone give you your preferred price?

It turns out banks, were the original high frequency traders. Then HFTs ate their lunch and banks started to whine. To illustrate this, let’s examine how HFTs are in the market to make a buck for themselves (and in the process, they provide liquidity for everyone). Some of the good and bad can be seen in the foreign exchange markets: Historically, banks are the primary liquidity providers in foreign exchange. Foreign exchange trading is generally done “over the counter” (OTC), but there are platforms that provide various ways of trading. HFTs try to beat banks at their own game. And HFTs might be good at taking advantage of idiosyncrasies of a particular trading platform. Banks realize they lose money on that platform because they get beaten by HFTs. They now have to choose whether to invest and also take advantage of the idiosyncrasies of that particular platform; or whether to stop providing liquidity there and focus on other platforms. Combined with a surge in regulatory overhead, there’s an incentive in the industry to consolidate, i.e. concentrate on fewer platforms. As the big banks leave some platforms, other investors follow.

So you tell me: are HFTs the bad guys because they scared away the banks? Or are the banks high frequency traders themselves, but with a better reputation (I’ll leave it up to readers to decide…) that were asleep as competition entered the market? I’m not trying to defend banks or HFTs, but want to show that every investor is in the markets for their own profit. The role of regulators is to align incentives so that greed can play out without taking unfair advantage. Regulators cannot regulate away bad decision-making; however, regulators can help design a system where bad decisions of any one player (the failure of a player) do not wreck the system as a whole.

When asked, Lewis says he is not trading complex instruments himself, but mostly buys index funds in his personal portfolio. In wonder whether Mr. Lewis – or most investors for that matter – is aware that index funds rely on HFTs to function. How do ETFs track their underlying indices? It’s through what Lewis might call a rigged game: market makers have an arbitrage opportunity, on steroids. Before going into details, let me first state: without HFTs, the ETF market would never have taken off. I’m not suggesting the way the market is functioning is problem free. In fact, any liquidity can evaporate in a heartbeat these days, setting the stage for future flash crashes. But before we lash out at an industry, it might be helpful to understand how it operates. Not all HFTs, as Lewis suggests, dig cables cross across the country to beat others with milliseconds. For an index fund, an ETF, to work, it heavily relies on HFTs. You can skip the bullet points below if you are not interested in the details, but for active investors, it may be worthy of their time to understand the process. Note that I’m intentionally using the terms market maker and HFT interchangeably:

  • Your typical index ETF holds a basket of, say, stocks. The ETF typically does not need to buy or sell stocks; instead, the ETF will issue new shares in return for receiving a basket of stocks from Authorized Participants (APs). Similarly, an ETF can hand over stocks to APs in return for retiring shares.
  • Market makers – these are HFTs – get ready to make a market by taking a basket of shares from the ETF; to do so, they have to provide the underlying stocks of the ETF.
  • Market makers are not gamblers, so they hedge their position by shorting the stocks in the market. If the ETF is tracking the S&P500, futures on the S&P500 might be sold. If you follow me so far, we now have
    • The ETF grew because a basket of shares was deposited;
    • The market maker owns a basket worth of shares in the S&P;
    • The market maker hedges its risk by shoring a basket worth of shares using derivatives.
  • Now imagine there’s demand for the ETF by investors. Without the HFT, the price of the ETF might rise and be disconnected from the underlying value of the index it is trying to track. This is how closed-end funds work. Yet most ETFs are pretty good at following their respective index. That’s because once an investor starts to bid up the ETF, the HFT in, offering the inventory for sale that they have built up. HFT simultaneously make a market for up to thousands of stocks.
    • And because the market maker is not in the gambling business, they will reduce their hedge position in the process.
    • At some point, the market maker will have depleted its inventory and eliminated its hedge position. Now the market maker can go back to the AP and request a new basket of shares (those familiar with the process will point out that market makers can also go short, but let’s skip those details for purposes of this example).
  • The same process can happen in reverse when there’s a flight out of the ETF. At any step along the way, the risk a market maker takes on is minimal, as long as they continuously rebalance their hedge book.
  • It shall be noted that this is the reason why even illiquid ETFs tend to trade near their NAV, as market makers can provide liquidity when no one else does. For anyone that considers trading an illiquid ETF, pick up the phone and ping the sponsor of an ETF who in turn will give the market maker a heads up to tighten the spreads. Lunchtime may be best for such orders, as the market maker doesn’t need to babysit the most active stocks, but can tell its systems to not back off when someone places an order with 100 times the average daily volume. It’s low risk to the market maker, as long as they can hedge their exposure and build up or reduce their hedge book.
  • I promised steroids, and here they come: the process above allows HFTs almost risk-free arbitrage. But exchanges go beyond that. Remember those fees that you pay when you trade on an exchange? Some of that goes to the broker, but there’s often a line item for exchange fees. The exchange uses the revenue to pay market makers to make a market. Depending on the security and the exchange, market makers get a rebate. Basically, if you pay $20 for a stock, a market maker might only be paying $19.995 for the same because of the arrangement they have with the exchange. By giving market makers a free lunch, they provide an incentive to them to be actively providing liquidity.

We hear headlines that some HFTs have only had 1 day of losses in over 1,000 trading days. My question is: what went wrong that day when the risks are so incredibly low? I can think of operational challenges when pricing or hedging becomes unreliable.

Back to Lewis: he may not be aware that for his index investments to work, he relies on a thriving HFT industry. This setup does create winners and losers – and as the foreign exchange example showed, losers can also be other big players in the markets. But just because someone is screaming that someone else is eating his or her lunch does not yet mean there is abuse. Importantly, as regulators get involved, I’m not optimistic that investors or any other stakeholders (other than lawyers) will be better off.

 
 

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