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Is Speed the Enemy?

The Impact of High-Frequency Trading on Financial Markets
Michael Lewis, in the words of the New York Times Michiko Kakutani,
possesses the rare storytellers ability to make virtually any subject both lucid and
compelling. He uses this gift for eloquence to craft a tale condemning rigged
markets, front-running, and high-frequency trading that is incredibly readable and,
on the surface, makes very good sense. Unfortunately, Lewis analysis is far too
simplified to adequately describe a system as complex as the one in which high-
frequency traders work. In reality, HFT has benefited the financial markets, and
Lewis book is irresponsible in its portrayal of the function and impact of high-
frequency traders. By excessively glorifying his protagonist, cutting down his
antagonist, exaggerating advantageous aspects of the debate and creating a simple,
moralistic tale about HFT, Lewis attempts to coerce the reader into coming to what
is, objectively, an incorrect conclusion. While he raises a few valid arguments, the
benefits of HFT are numerous and strong enough to completely outweigh his
arguments, and besides that, the problems he articulates are not nearly as big as he
makes them out to be. Articles written by the very institutional investors that Lewis
claims to be trying to defend from speed traders trumpet the systemic benefits of
HFT, and temper the negative claims Lewis makes in Flash Boys. In looking at the
incentives of Lewis and others involved in the book, it should come as no surprise
that they have made the assertions and generalizations they have.

Lewis Narrative
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Lewis uses writing techniques that powerfully draw the reader into the
narrative, connect them emotionally to the characters and to the issues at hand, and
simplify the problem into a dichotomy of more or less black and white. He does this
by establishing clear protagonists and antagonists, as well as by using hyperbole
and exaggerating aspects of the story that help his argument. This leads to a book
that is easy to read and engage in, but that gives a very unbalanced picture of what
high-frequency trading really is and how it affects the economy.
In his typical fashion, Lewis skillfully weaves the story of a few individuals
into a statement about a broad issue. In Flash Boys, he focuses largely on Brad
Katsuyama, the former trader for Royal Bank of Canada who was frustrated and
confused with the way the market was responding to his trades, and decided to
investigate. Lewis follows Katsuyama as he tries to get to the bottom of why he cant
seem to trade large blocks of stock at a price consistent with the quotes on his
computer screen. On the other side, he shows Dan Spivey, his construction team
and the banks and trading firms to whom they sell access to their fiber-optic cable
connecting exchanges in Chicago and New Jersey. It is through these micro-
narratives that Lewis shows much of his bias and leads the reader to an unbalanced
conclusion.
It is very apparent in the writing that Lewis will try to paint his protagonist
in a very positive, heroic light, and subtly put down the antagonists. As Jonathan
Zhou writes in his article defending HFT in the Harvard Crimson, In Lewiss
narrative, High Frequency Trading is the evil man, Katsuyamas mutual fund clients
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are the righteous and the weak, and Katsuyamas new exchange is the shepherd that
protects the righteous from the evil. This bias can be seen right off the bat, in
discussing the construction of Spiveys cable. Lewis writes, two hundred and five
crews of eight men each, plus assorted advisors and inspectors, were now rising
early to figure out how to blast a hole through some innocent mountain, or tunnel
under some riverbed (Flash Boys, pg. 7, emphasis mine). This is an unnecessary
potshot at the environmental implications of Spiveys project, which, even if they are
severe, are not important in the debate about HFT that Lewis is ostensibly reporting
on. This passage is a blatant example of Lewis intentionally biasing the reader
against his chosen antagonist, for reasons outside the scope of his argument. This is
extremely irresponsible journalism, especially in the context of such an important
debate.
Even easier to spot are Lewis aggrandizing descriptions of Brad Katsuyama.
In a book that has already had a huge impact on serious, policy-shaping debate
about financial regulation, Lewis just so happens to include an anecdote about Brad
Katsuyama, the nice guy from Canada, sneaking food from the excessive corporate
meals and bringing it down to homeless people on the streets (pg. 24). Lewis
doesnt stop there, though; forthcoming are anecdotes about Katsuyama being such
a team player that he passes up the opportunity to be a high school track star to
focus on team sports; Katsuyama giving up the chance to go on scholarship to any
university in the world to go to little Wilfrid Laurier University in Canada with his
girlfriend and football teammates; and Katsuyama heroically calling out RBC in a
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diversity meeting for making him feel like a minority (pg. 25). About five pages after
meeting him, one could be forgiven for wanting Katsuyama as a son in law.
In addition to deifying certain characters and demonizing others, Lewis is
quick to use hyperbole to accentuate the points of his story. This troublesome
tendency is extremely evident when he is describing the difference between the way
the market worked after Katsuyamas slowing algorithm was applied to trades, and
before. When the algorithm, nicknamed Thor, slowed the fastest trades so that
they were all processed by the same exchanges at the same time, orders would all be
processed and the market functioned as one might expect. But without Thor, if
orders arrived even a millisecond apart, the market vanished, and all bets were off
(pg.60). This is clearly hyperbole; to say that markets vanished if people werent
using Thor to slow their fastest orders implies that no one in the financial world at
the time could buy or sell stock. Of course, Lewis would never argue this, but the
problem when one is writing about complex topics such as high-frequency trading is
that the reader will not necessarily be able to discern what is and is not meant to be
taken literally.
Another, similar quote sees Lewis comparing the haves and have-nots of
the market, the dichotomy he uses to refer to high-frequency traders and the rest of
the public, respectively. He writes, the haves enjoyed a perfect view of the market;
the have-nots never saw the market at all (pg. 69). Once again, this language is over
the top and could be misleading to the largely layperson audience that Michael
Lewis targets. Writing like this will only add to the sensationalism surrounding this
topic, and this sensationalism will be counterproductive to real, useful progress. A
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final and particularly amusing example of this is this passage about the greatness of
the U.S. financial system: What had once been the worlds most public, most
democratic, financial market had become, in spirit, something more like a private
viewing of a stolen work of art (Pg. 69). This is funny, considering the previous
books Lewis has written about the United States financial system havent exactly
trumpeted the fairness, transparency, or democracy of the system. Is it really the
case that the markets are so much worse now than they were when brokers made a
fixed commission on each trade and didnt have to compete at all? Or before the SEC
began to regulate exchanges? Or better yet, when Lewis was a twenty-three year
old kid peddling bonds to institutional investors, or when banks were leveraged
thirty-plus to one and churning out mortgage-backed securities? Lewis didnt
mention HFT much in Liars Poker, but the financial crisis seems to be a whole lot
worse than a tenth of a percentage point haircut on big trades.
The dangerous thing about Lewis painting the characters into such clear
moralistic roles and in carefully choosing which facts to highlight to support his
claim is that they make the book so enjoyable to read and easy to digest. Theres a
clear good guy, a clear set of bad guys, and a simple, moralistic narrative that even a
financial layperson can follow without much trouble. The trouble is, a financial
layperson should not be able to read a 300 page book and have a well-informed
opinion of something as complex as high-frequency trading. What the superfluous,
judgmental excerpts in Flash Boys do not do is provide objective analysis about the
impact of HFT (all of HFT, not just a subset of it) on the financial markets and, by
extension, the world economy. What is worrisome is that there are many influential
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people, who are of reasonable intelligence but are not particularly educated about
finance, who will read this book and be drawn in by Lewis stylish writing. This
book will give them, in my opinion, a drastically skewed version of the real state of
the financial markets in general, and the effects of high-frequency trading more
specifically. In turn, these people will write policies that may be ineffective or
detrimental in controlling the financial markets.

What Lewis is Truly Arguing

In order to really analyze the points Lewis makes about HFT, one must
explicitly understand it without the distraction of the constructed morality,
characters and narrative. When the reader finally sifts through the extraneous
typifying and drastic hyperbole of Flash Boys characters, Lewis main point is
roughly as follows (this is my writing, and not Lewis):

Our financial markets are no longer controlled by humans, but instead
by algorithms trading at the speed of light. This is bad because only a
select few have access to the speed necessary to profit in this system,
and those who do have access are essentially front-running slower
investors to rig the markets against them. The people who are being
harmed by this are the little guys who have money in the markets but
do not have the technology to keep up.

Some concessions to Lewis

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There are some valid points that Lewis makes, and these points should be
addressed by lawmakers and, perhaps, regulated. The first is his position on flash
trading, wherein HFTs can purchase a speed advantage on information outright
from an exchange. The second is his argument against Spiveys glass cable
subscription. These two issues should be carefully considered, and the conclusions
should be driven by data, not ad hominem attacks on the groups and people in
question.
The argument for the practice of flash trading is that it provides liquidity
and reduces latency, increasing the size of orders that can be filled on the exchange.
However, this really does seem problematic, and akin to front running and/or
insider trading. When there is an event that will move markets, it really seems
legally and, certainly, ethically sketchy for certain groups to pay for the right to act
on that information early.
It is important that an objective body looks at data from the exchanges and
decides what the true costs and benefits to this sort of technology are. While
Katsuyamas experience of the price of his orders running away from him does make
it sound like the system is rigged in favor of the speedier traders, it seems very
possible that the average price paid per share has improved with the advent of the
technology, so even though Katsuyama sees his price rise, he is really better off due
to the speed traders. In this case, the rip off effect is an illusion, and is really just
the markets responding faster to information than they once did.
Spiveys subscription service information cable is also very problematic. I
believe that kind of service should be regulated, because the barriers to entry are so
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high, and it involves such massive interstate infrastructure, which is potentially
environmentally damaging. The competitive forces of the market cannot really
function properly in the business of connecting different exchanges, because we
cannot have 15 different cables running from Chicago to New York, and because the
capital requirements and risk to build systems like these are so enormous. As such,
it makes sense to have the government regulate this service in a similar way that it
regulates railroads and utilities.
These two concerns are important and should be looked at by a responsible
governing body (though how possible that is certainly is up for debate.) It is of the
utmost importance, in this as well in any other economic decision, that people put
aside their knee-jerk, emotional responses and consider the costs and benefits of
each of the possibilities. It is a poverty that Lewis is promoting so much of the
former reaction, and so little of the latter.

In Response to Lewis Position

Lewis barely acknowledges the benefits that HFT strategies have had to the
economy, including to small investors. These benefits shouldnt be taken lightly
when considering what to do about HFT, and they certainly shouldnt be completely
glossed over in such an important and popular book. Among the positive effects of
HFT on the broader economy are increased liquidity, lower volatility, and lower
trading costs. These have helped investors, particularly small ones, by decreasing
transaction costs and making it easier to buy and sell stock. Finally, though Lewis
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makes HFT seem like a massive industry, it really is not very large compared to the
rest of the gargantuan financial sector. This means that it probably should not be
the focus of regulators, who should instead be looking at giant, systemic problems
that could threaten the whole economy.
Providing liquidity is a popular catchphrase among practitioners of HFT.
One of the most successful market makers, Spot Trading, LLC, writes on their
website that a market maker is obligated to post two-sided quotes across a
minimum amount of series and symbols as determined by specific exchange rules.
In exchange for providing liquidity, market makers receive certain benefits such as
priority of trade allocations, reduced exchange fees, and favorable treatment of
regulatory capital. The benefits that the market maker receives, of course, are what
Lewis has problems with, but the fact that the firm provides liquidity to the market
should not be ignored, as it means that more people can trade in a given security at a
given time. This is good for the market and the people in it.
Lowering volatility in the market is another useful function of HFTs.
Although Lewis is very skeptical of the fact that computers, rather than humans,
increasingly dominate exchanges, it is true that computers cannot be swept up in
the human emotion that has led to so many bubbles and crashes over the years.
Certainly, program trading can lead to market-wide issues such as the Flash Crash,
but this is not an irrationality, instead it is more a technical problem. When they
work properly, algorithms will always be rational. This should, theoretically,
decrease the volatility of the market overall, and the vast majority of investors can
benefit from less risk in the financial markets. Also, because many HFT firms want
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to be flat in terms of market movement, their trading strategies can reduce market
volatility, since they do not attempt to ride bull markets and short bear markets.
This is something that Lewis glosses over, and this is a huge disservice to those who
practice high-frequency trading strategies, as well as readers who are trying to
decide what to make of the industry.
Lower trading costs are a third positive aspect of HFT and are very
important. The rise of technology in finance has seen the cost of trading drop
dramatically, and this is a very good thing for investors. Menkveld (2013) studies
the entrant of a new HFT firm, and finds that after the HFT firm enters, spreads
decrease by 50%. This means that for small investors who are crossing the spread,
they could be paying half of what they would have paid in effective transaction
costs, because of the market-making of the newly entered high-frequency trader.
From Jonathan Zhou of the Harvard Crimson, If a small investor wanted to buy 100
IBM shares in 1994, he had to pay around $10 in brokerage fees, and at least six
dollars in bid-ask spread costs to a specialist on the floor of the New York Stock
Exchange. Today, the same trade will cost $1 in bid-ask spread thanks to the tight
spread that high frequency traders provide, and the investor may not have to pay
commission at all (emphasis mine). These statistics go to show that, contrary to
the claims of Michael Lewis, the markets have become more democratic. Whether it
is directly caused by HFT is up for debate, but it certainly seems NIX, REPLACE
WITH IS hard to argue that the markets are rigged against small investors given
the data on how much less costly it is to participate in the market now as opposed to
just twenty years ago. Though it does not show the most recent data, when HFT has
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really taken off, the following chart, from Rob Wiles article in Business Insider,
shows the trend in trading costs, and its clear to see that active traders are better
off with respect to fees now than they used to be.




Wile sums up the benefits of competition and technology in the brokerage industry:

Turnkey desktop trading programs have lowered fees to as little as $7
a trade, and there's never been more cheap or free information
available to anyone interested in markets. It didn't used to be that
way.

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So, when Lewis waxes poetic about how democratic and open the markets used to
be, he is going directly against a very clear set of data that suggest just the
oppositemarkets have been getting more efficient, and this has benefitted small,
active investors.
These benefits of high-frequency trading are significant and certainly should
not be discounted when deciding what sorts of regulation to impose on the industry.
There is strong evidence that the advent of speed trading has helped small investors
and made for more democratic and efficient markets, not less.
Finally, HFT simply isnt as big as Lewis makes it out to be. From Jonathan
Zhou in the Harvard Crimson, the total industry revenue of HFT is about $22 billion,
or about 1/54
th
of the $1.2 trillion financial industry. Meanwhile, David Einhorn,
who supports the newly formed IEX, has a net worth of more than the market cap of
the biggest HFT firm. These statistics certainly make it seem like there are bigger,
more important things for regulators to be worrying about when it comes to the
financial sector and the economy at large.

Outside Support for High-Frequency Trading

AQR Capital Management is a fund with upwards of $90 billion in assets
under management. Two Principals at AQR wrote a Wall Street Journal article on
high frequency trading, and in it is the following:

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How do we feel about high-frequency trading? We think it helps us. It
seems to have reduced our costs and may enable us to manage more
investment dollars.

The two Principals who wrote the article are Clifford Asness, who is a finance PhD
from the University of Chicago and studied under recent Nobel Laureate Eugene
Fama, and Michael Mendelson, who has four degrees from MIT and an MBA from
UCLA. In short, they know what they are talking about. Combined, they have 42
years of experience dealing directly with the financial markets. Of course, Michael
Lewis has an impressive background in his own right, with a bachelors from
Princeton and a Masters in Economics from the London School of Economics and a
short but prosperous career with Salomon Brothers, but the rigouresness of the
pedigrees of these two investors makes Lewis background seem quite soft in
comparison.
Asness and Mendelson make the assertion that, from their view as managers
of a large fund, high-frequency trading has benefitted them and, by extension, their
investors. They are not overconfident in their argument, but they say that their
transaction costs have gone down because of HFT, and they accuse Lewis of a clear
conflict of interest: in our profession, what we saw on 60 Minutes is called "talking
your book"in Mr. Lewis's case, literally.
Asness and Mendelson write that they think HFT has lowered their costs, but
they cant be certain. However, they devote a lot of effort to understanding our
trading costs, and (their) opinion, derived through quantitative and qualitative
analysis, is that on the whole high-frequency traders have lowered costs. This
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healthy skepticism combined with rigouresness factual analysis is totally absent
from Flash Boys and makes Asness and Mendelsons argument much more robust,
because they acknowledge that they dont know all the answers, but they show a
willingness to scientifically search for them instead of crafting an argument out of so
much anecdotal evidence.
While Asness and Mendelson are in favor of HFT on balance, they do give
some ground to the opposition, writing, some of them may negotiate advantages
that might be bad for markets. Worse, these arrangements tend to be little
understood by the broader range of market participants. This acknowledges the
problems caused by things like the cable and its barriers to entry, but it does not
blow them out of proportion. The stance that Asness and Mendelson take is aginan,
much more balanced and rigorous than the sensationalist claim made by Lewis, that
the stock market is rigged.
Asness and Mendelsons balanced, critical approach allows them to take into
account the fact that most of HFT is not latency arbitrage, the strategy that Lewis
portrays as the entirety of HFT and decries as rigging the markets. Market-making
firms make up a huge amount of HFT activity, and these firms actively lower spreads
and, in doing so, benefit market participants. They describe the role of these firms
as follows:

Much of what HFTs do is "make markets"that is, be willing to buy or
sell stock anytime for the cost of a fraction of the bid-offer spread.
They make money selling at the offer and buying at the bid more often
than they have to do it the other way around. That is, they do it the
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same way that market makers have done it since they were making
markets in Pompeii before Mount Vesuvius halted trading one day.

By hearkening back to the ancient markets in Pompeii, Asness and Mendelson show
that much of HFT isnt really revolutionary or scary, but just a technologically
advanced way of doing something that traders have done for literally thousands of
years.
Even more damning than AQR in his criticism of Lewis ideas, given his
position and background, is Bill McNabb, the CEO of Vanguard. Vanguard, which
became the worlds largest mutual fund company by championing low costs for the
small investor,(Financial Times) is relatively straightforward in its strategies and
friendly to individual investors, providing largely index funds with low management
fees. So it is striking to hear its chief oppose Lewis, who bases the thesis for Flash
Boys on the implication that the little guy is being hurt by this rigged system. The
following excerpt from his interview with the Financial Times shows McNabbs
skepticism about the claim that high-frequency traders are front-running buyers of
big chunks of stock, and thus costing individuals money:

He said Vanguard had examined these so-called market impact
costs, by looking at tracking error in its exchange-traded index funds.
We actually have a really good perspective on this and theres no
question in our mind that the cost to investors through funds has
come down, he said.

McNabb is in an excellent position to judge the impact of HFT: he has access to the
longitudinal trading data of a firm that manages $2.8 trillion in assets under
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management. And from his perspective, his clients have benefitted from the lower
spreads caused by market-making HFTs.

Lewis and Co.s Motivations

Lewis, it seems, has a generally altruistic mission in his writings. Beginning
with Liars Poker, wherein he wanted to convince some bright kid at Ohio State
University who really wanted to be an oceanographer [to] spurn the offer from
Goldman Sachs, and set out to sea, continuing with exposing the financial lunacy
The Big Short, and now with Flash Boys, he has used his storytelling ability to
provoke a slew of public discourse and thought. But this power brings a certain
responsibility to report stories in a balanced, critical and unbiased way. With Flash
Boys, Lewis has failed to do that. There are real costs to this sensationalism. Asness
and Mendelson write, with regard to financial reform related to HFT, the recent
fusillade of hyperbole about HFT practices threatens to derail this effort and refocus
attention where the problem isn't. In raking up contrarian stories about HFT,
Lewis diverts public effort and money from areas where these precious
commodities would be better spent. He may even be hurting small retail investors
in working to further regulate HFT. The AQR Principals write,

How HFT has changed the allocation of the pie between various
market professionals is hard to say. But there has been one
unambiguous winner, the retail investors who trade for themselves.
Their small orders are a perfect match for today's narrow bid-offer
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spread, small average-trade-size market. For the first time in history,
Main Street might have it rigged against Wall Street.

Figuring Out the Incentives

To get a grip on why Lewis claims might be as skewed as they are, one must
examine his incentives. Lewis sells books to a popular audience, and has been
promoting the book through popular media. As Matthew Phillips writes in Business
Week, Lewis pitch has been speed traders have rigged the stock market, and the
biggest losers are average, middle-class retail investorsexactly the kind of people
who watch 60 Minutes and the Today show. I believe that Michael Lewis is, in
many ways, an admirable person and a terrific writer. It seems that he truly
believes in what he writes, and wants to improve the world through that writing.
But, just like the brokers that Schwed describes in Where are the Customers Yachts
who fool themselves into believing in the stocks they are peddling, Lewis has been
blinded by his incentives, and has gone completely overboard in his claims. To take
a wonderful quote from Asness and Mendelson, making mountains out of molehills
sells more books than a study of molehills. At the end of the day, he wants to
promote and sell his books, and his drive to do this led him to come to a
sensationalized and oversimplified conclusion.

In Summary

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Michael Lewis practiced irresponsible journalism in writing Flash Boys: A
Wall Street Revolt. He turns a complex issue into a simple moralistic tale, complete
with a golden-boy protagonist in Brad Katsuyama and a slew of well-defined
antagonists in the perpetuators of HFT. He makes frequent use of hyperbole and
anecdotal evidence instead of staying grounded in fact, and as such the reader at
should not accept at face value the generalizations that Lewis makes. Several very
well known investors have stepped up and defended HFT, saying that it helps
market liquidity, lowers trading costs, and decreases market volatility. Some of
these investors pointed to Lewis desire to sell books and Katsuyamas incentives to
promote his new stock exchange as reasons for the biased nature of the book. No
matter what the motivations, this book is dangerous. Lewis is such a talented and
popular writer than many people will be caught up in his argument, and this will
impact the policies regulating high-frequency trading going forward.

What to Make of it All?

So what should be done about high-frequency trading? It is, of course, not an
easy answer. One possibility, which would be, at least, simple and cheap, is to do
nothing. As Philips writes in Business Week, Lewis gives the impression that high-
frequency trading firms are rolling in dough. The reality, however, is that HFTs best
days are behind it, and many firms are barely keeping their heads above water.
This implies that HFT, like so many financial innovations before it, experienced a
boom when it was new to the market, but now the competitive forces in the market
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are dragging down profits. If this is the case, then perhaps regulation is
unnecessary, as the market may reach an equilibrium where firms are no longer
incentivized to compete on speed.
While letting the market do the job is temping, in my opinion, something else
does need to be done to keep HFTs in check. Specifically, transparency should be
necessitated more than it is, precisely so that regulators and the public have a
clearer picture of what is going on in the markets. Asness and Mendelson write, a
little more transparency would be good here, and the market venues that have been
offering these deals have been moving in that direction. They should move faster.
This makes sensethe exchanges and regulators should work together to promote
transparency and consistency. Systemic risk that HFTs pose (as an example, the
flash crash) is another valid issue that should be examined. These risks seem real,
and its necessary that the technology and trading protocol be regulated to the point
that HFTs dont pose a risk to the entire economy. Again, the advice of Asness and
Mendelson is sound: Real work is necessary to improve and safeguard a complex
and still reasonably new system. We shouldn't get ourselves dragged into a hyped-
up war over a matter that doesn't affect investors very muchand where, to the
degree that it does, we'd argue that the effect is easily a net positive. In other
words, regulators and financiers should work together to ensure that our financial
system is stable, robust, and as transparent as possible. It is essential, though, that
the people with the power to enact change sidestep the temptation to get upset and
indignant about high-frequency trading based on anecdotal and exaggerated
evidence, because at the end of the day it has been a benefit to the world economy.
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Works Cited

Kakutani, Michiko. "Touring The Ruins Of the Old Economy." The New York Times.
The New York Times, 26 Sept. 2011. Web. 28 Apr. 2014.

McNabb, Bill. "Vanguard Chief Defends High-frequency Trading Firms -
FT.com." Financial Times. N.p., 24 Apr. 2014. Web. 28 Apr. 2014.

Wile, Rob. "Back In The Day, Brokers Got Away With Murder In Trading
Commissions." Business Insider. Business Insider, Inc, 31 Mar. 2014. Web. 30 Apr.
2014.