The recent publication of “Flash Boys,” the latest best-seller by Michael Lewis, has introduced to many Americans the inscrutable practice of high-frequency trading—algorithm-wielding intermediaries who use superior computing and connectivity to buy and sell securities in unprecedented volumes and at unprecedented speeds.
No one knows for sure the full effect this new breed of traders is having on traditional investors and financial markets. But Jonathan Brogaard is working on the question. An assistant professor of finance at the University of Washington Foster School of Business, Brogaard has become one of the foremost academic authorities on high-frequency trading. We asked him to share the wealth on this powerful new force in the financial markets.
Q: Let’s start at the beginning. What is high-frequency trading?
JB: High-frequency trading (HFT) is a combination of technology and trading strategy. It is generally defined as the rapid and continuous buying and selling of a financial asset while taking only small intraday positions and ending the day with no inventory.
Should investors fear HFTs, who are depicted as predatory skimmers that enjoy an unfair advantage from a rigged market in Michael Lewis’s new book?
No. When an individual buys or sells a stock her trade never even reaches the stock market (NASDAQ, NYSE, etc.). Instead the trade is internalized. That is, the broker deals with your trade in-house and matches your desire to buy with one of its other clients’ desire to sell.
Could you put HFTs into some historical perspective?
HFTs have taken over the role of the intermediary. Before HFTs there were traditional market makers who would buy and sell stocks continuously throughout the trading day and try not to take a large directional position. The comparison isn’t perfect, though, as HFTs hold a position for a few seconds, while some traditional market makers would be willing to hold positions for days and even weeks.
We now know that HFTs make sizeable returns. But putting their profits in context with traditional market makers they look like a great deal. Traditional market makers made about eight times as much per trade as do HFTs.
What role have intermediaries traditionally played in market dynamics?
Intermediaries are very important for continuous markets. They smooth out the demand for buying and selling by shifting positions over time. That is, when there is a fundamental seller there may not be a fundamental buyer. The intermediary would buy the shares from the fundamental seller temporarily and eventually sell to the fundamental buyer when he came to the market.
Has the body of empirical findings come to any consensus yet on HFT activity? What do the data tell us?
That is a very broad question. Let me just say that the evidence is mixed. Generally, the research shows that HFT benefits the market—that is, it appears to improve liquidity and price discovery. However, there are also well-documented results showing that some aspects of HFT have negative consequences. For instance, HFT’s net market improvements seem to derive from certain HFT firms that supply liquidity. But there are others that take liquidity from the market, and may harm price efficiency and overall liquidity.
Are there signs that regulators are beginning to understand HFTs enough to enact some useful regulations/safeguards?
Regulators are doing the best they can with the limited resources that have been made available to them. There is still much to be done. Unfortunately academics can only do so much as the data necessary to understand HFT is often proprietary.
Given that the pace of trading in general is continually accelerating, does speed appear to be good or bad for the efficiency and quality of markets overall?
Speed appears to be beneficial to markets. Faster markets allow investors to (almost) instantaneously know what is going on in the market so that they have current information to make informed decisions. One of my papers shows that accelerating computing and connectivity speed makes the market better for all participants. This is surprising because, at this point in the development of exchanges, a speed upgrade directly benefits only a handful of firms who are able to utilize the faster speed. However, their activities create externalities—unintended market-wide benefits—that make the market better for ordinary investors as well.