Although computerized high-frequency trading (HFT) has existed for the past 20 years, Michael Lewis’ book, Flash Boys, has made HFT a hotly debated topic recently. Because there’s much confusion about the role HFT plays in the financial markets – let alone whether HFT is good or bad – I thought I would review HFT and how it affects LNWM clients.
What Is High-Frequency Trading?
HFT refers to a wide variety of algorithm-based strategies implemented via computers to buy and sell sometimes thousands of stocks within milliseconds (one-thousandth of a second). Today, roughly 50% of trades on U.S. stock exchanges are estimated to be generated by such computer-driven transactions.
Big changes in the 1980s. Enabled by computerization, HFT and “dark-trading pools” (private trading forums) started to function in the 1980s as intermediaries, providing market liquidity (similar to the role played by “market makers”). Using computers to automate the process, HFT firms drove down the price of trading, especially in illiquid stocks – savings that are shared with investors. The trend toward lower bid/ask spreads appears to be continuing today.
Competition among HFT firms typically compresses bid/ask spreads. However, the HFT firms also take a bit of the spread for themselves. Some of this “compensation” comes from accurately predicting large trades — or paying the exchange for trading data — and positioning the HFT firm to capitalize on the trade flow.
Not surprisingly, HFT firms’ compensation has shrunk as HFT competition has increased. One common estimate from Vanguard is that revenue from HFT has dropped 86% in the last five years — from $7 billion down to $1 billion.
Does High-Frequency Trading Harm LNWM Clients?
This is a tricky question. HFT is a developmental change in how stocks are traded. Like most changes, it has both positive and negative consequences. In looking at the heated debate regarding HFT, it’s important to remember that every proponent and antagonist has something to be gained or lost from convincing regulators to support their view.
Benefits from HFT:
- Greater market liquidity.
- Improved integration of electronic stock exchanges, which increases the transparency of trades.
- Lower transaction costs for investors. Vanguard estimates that HFT has reduced transaction costs during the past decade by 1% annually for each “round-trip,” or buy/sell transaction. A 1% reduction in costs each year is a significant benefit to our clients.
Negatives from HFT:
- Trading crises, such as the “flash crash” in May 2010, are more likely as the algorithms mature and become ever faster and more complex.
- Some HFT firms purchase preferential data feeds and access from the exchanges. This raises concerns about the exchanges’ willingness to sell preferential access, which HFT firms can then use to determine — and capitalize on — the direction of large trades.
- This practice, however, may have less of an impact on most retail investors than it may initially appear. The race to ever-faster transactions and earlier access to data among HFT firms principally helps them to compete against other HFTs, which works in the long run to reduce bid/ask spreads. Retail investors and even most of the large, institutional investors, trade too infrequently and typically in lots too small to generate sufficient profit for HFT firms.
- Also, nearly all mutual funds and large institutional investors hire trading professionals to prevent their trade data from getting out to competitors before they’re able to transact. These hired traders attempt to confuse competitors by entering trades at several exchanges at different times throughout the day. In many cases, traders also put in small buy orders when attempting to sell a large number of shares (or sell orders for a stock they’re attempting to buy) to hide their ultimate objective.
- Note: “Front-running” is when a broker or other trading intermediary acting on behalf of an investor trades against the investor before executing the trade. HFT firms, like all other market participants, are investors’ competitors, not their agents or confidantes. So when HFT firms trade on information provided to them by the exchanges or captured by the HFT firms themselves, this is not front-running, as Michael Lewis indicates in his book. The buying or selling of information is not illegal, although special access is a concern.
- HFT adds stress to the infrastructure of electronic exchanges. However, given the fact that HFT firms are a major source of revenue for these same exchanges, they should have sufficient incentive to bulk up their infrastructure to handle the additional strain.
How LNWM Limits the Negative Impacts of HFT
We do not trade unnecessarily. At LNWM, we have a long-term focus and a bias against transactions. Even given narrow bid/ask spreads, transactions come at a cost to our clients, often trigger taxable events and increase the probability of an operations error.
We direct large trades to an intermediary that can successfully manage the transaction. Large buy or sell orders for illiquid stocks should not be placed as a single order. Rather, they should be broken into several smaller orders to be placed at different times of the day and at different electronic exchanges. This is the procedure that Schwab, for example, uses when we use its trading platform for large or illiquid transactions.
We avoid trading when market volatility spikes. If stock prices are changing very rapidly with no obvious catalyst (such as during the 2010 “flash crash”), we simply do not trade that day. This is the benefit of having a long-term investment perspective. Delaying our transactions by a day or two will seldom have a profound effect on our long-term performance.
The Bottom Line
We believe LNWM clients are largely shielded from the negative effects of HFT. While the changes within the markets over the last several decades can be troubling, it’s important to note that LNWM maintains a long-term perspective and bias against trading unnecessarily.
LNWM weighs all the costs associated with a transaction — including potential price movement, explicit trading costs, implicit trading costs and tax consequences – before executing a trade. This allows us to benefit from the improved liquidity and reduced bid/ask spreads, while mitigating the exploitation of trading information and volatility spikes that HFT may induce. Additionally, none of the asset managers used in LNWM client accounts have investments in HFT firms.