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 storyteller’s 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 can’t

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 Lewis’s

narrative, High Frequency Trading is the evil man, Katsuyama’s mutual fund clients

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are the righteous and the weak, and Katsuyama’s 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 Spivey’s 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 Spivey’s 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

doesn’t 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 Katsuyama’s 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 weren’t

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 world’s 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 haven’t 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 didn’t 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 didn’t

mention HFT much in Liar’s 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. There’s 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 Spivey’s 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

Katsuyama’s 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.

Spivey’s 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 shouldn’t be taken lightly

when considering what to do about HFT, and they certainly shouldn’t 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 Wile’s article in Business Insider,

shows the trend in trading costs, and it’s 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 opposite

—markets 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 isn’t 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 1/54th 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 bachelor’s 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 can’t 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 Mendelson’s argument much more robust,

because they acknowledge that they don’t 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 Mendelson’s 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 isn’t 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 world’s 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 McNabb’s

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 there’s 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 Liar’s 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 investors—exactly 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 Katsuyama’s 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 HFT’s 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 sense—the 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 it’s necessary that the technology and trading protocol be regulated to the point

that HFTs don’t 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 much—and 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.

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