High frequency problems
High frequency trading (HFT) has scuttled into the limelight this year since the publication of Flash Boys, Michael Lewis’ recent book on the subject. While most people agree that faster, smarter trading is generally good, and that rigged markets are an entirely bad thing, there is by no means agreement where HFT fits in.
Jim McCaughan, CEO of Principal Global Investors, is one long-standing critic of HFT strategies, and has gone on record to describe some of them as “structured front running schemes”. Speaking at the Milken Global Conference in Los Angeles this year, McCaughan said the use of algorithms to trade in front of another buyer is fraudulent conduct and that payment for retail order flow is a major abuse. Few European investors would disagree with him.
Of course, not all HFT strategies are alike. Market-making HFT strategies add liquidity to the market, for example, as do index arbitrage HFT strategies that use technology to take advantage of price differentials on public markets.
Regulators are aware of issues and have identified areas for action. Clearly, they have their work cut out in keeping pace with technology. In Europe, where HFT is, admittedly, less of an issue, MIFID II makes explicit mention of the subject. In the US the SEC is looking at the so-called ‘maker-taker’ broker rebate model that can cause conflicts of interest.
But competition and smarter regulation means HFT has become less profitable. Indeed, overall profitability of US equity HFT decreased from $7.2bn (€5.3bn) in 2010 to $1.1bn in 2013, according to TABB Group.
So should long-term investors worry about HFT? After all, a long-term investor executing an order for a stock it intends to hold for months or years will probably not worry unduly about very small price variations over time periods measured in microseconds.
Of course, investors should worry if rapid-fire HFT trading is creating exchange costs that are passed on to them through excessive order cancellation, for example. Again, this is not
seen as a problem in Europe as much as it is in the US.
And they should worry if HFT strategies are increasing overall market volatility. But while the rise of HFT in recent years has coincided with increases in equity market volatility, that period also saw the market crash of 2008 and the subsequent turmoil. It is hard to prove a cause-and-effect link between the two.
Some large pension funds see a key distinction between long-term buy-and-hold and trading – one group is socially useful, whereas the other is not. They should be prepared to add precision here: what precisely is the cut-off point between a long-term investor and a short-term one, and can anyone prove that very short-term investors are necessarily a bad thing?