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Counterpoint to Michael Lewis …

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Counterpoint to Michael Lewis …

Republished from: “Forbes”
Michael Lewis Is Entirely Wrong About High Frequency Trading Hitting The Little Guy

It appears that Michael Lewis has a new book out today, on in which he talks about high frequency trading on the stock market. And he makes the claim that this practice in some way takes money from the little guy to give to the capitalist profiteers running those HFT systems. No, I’m sorry but this will not do. The effect on the small investor is entirely the other way around. Small investors benefit from the existence of HFT. So do large investors in fact. It could be that HFT has other risks and problems. Perhaps it makes the markets more fragile at times of stress, there’s a possibility, as with the Flash Crash that people can misprogram their algos and thus make the market horribly volatile for a short time. There’s even been a case of someone bankrupting their firm by the misuse of the training part of the software package (Knight that was).

But Lewis’ contention is that in the average operation of the HFT market it is somehow taking money from the small investor and handing it over to those plutocrats: and this is something that just isn’t true. Here’s a report of what he said on 60 Minutes yesterday:

Robots aren’t just taking your jobs, they’re stealing your profits on stock trades, too.

The stock market has been rigged by a group of tech-savvy insiders who are using super-computers to game trades at the expense of normal investors, journalist Michael Lewis charges in his new book, “Flash Boys.”

OK, so how do they do this?

The robots’ high-speed networks allow them to buy the stocks milliseconds in advance — enough time to push up the price for the investor that had made the original order.

“They’re able to identify your desire to, to buy shares in Microsoft MSFT +2.08% and buy them in front of you and sell them back to you at a higher price,” Lewis said. “The speed advantage that the faster traders have is milliseconds … fractions of milliseconds.”

The villains are a “combination of these stock exchanges, the big Wall Street banks and high-frequency traders” who are bagging billions every year with the practice, Lewis said in an interview Sunday with “60 Minutes.”

The victims, Lewis adds, are “everybody who has an investment in the stock market.”

My word, how dastardly.

However, reality is a little different. Yes, there most certainly are people playing around with HFT, they do use high speed fibre optics, locate their servers right next to the exchange so that they can move faster than anyone else and so on. But the effect on all of the other traders in the market is entirely the opposite to the one that Lewis identifies.

Apologies, but a little bit of the economics of a stock market for a moment. So, it’s a market where people buy and sell things: clearly and obviously. And there’s also always a difference between the price at which the market makers (those who promise to both buy and sell in a particular stock) are willing, at any one moment, to buy or sell the specific stock under discussion. This is called the spread. It’s possible for there to be a wide spread in a particular stock (or bond, currency, whatever). One percent can happen in certain very small markets. The price at which you can sell to the market maker is 1% below the price at which you can buy, at the same time, that same item from that same person. It is, if you like,, a tax upon your activity, 0.5% either side on every buy or sell order. It’s also, from the market maker’s side, his fee for being ready to buy and or sell that item at any time that the market is open.

We can also have markets where the spread is 1 basis point, or 0.01% of the total value. Truly large markets (say, the US dollar to euro exchange rate) work at about these sorts of spreads. Thus the fee, or the tax, for trading in this is 0.005% either side of a buy or sell order. You can see that the buyer or seller is getting a better deal in this second sort of market, with the low spread, than they are in the first, with the high spread.

We also know what it is that determines whether a market has a high or low spread: the liquidity in that market. This is just the jargon method of saying that the more people buying and selling whatever it is in larger and larger quantities then the smaller that gap between the buying and selling price will be. The $ to € market is one of the largest markets on the entire planet, possibly as large as $1 trillion a day. This is hugely larger than the market in any individual stock (yes, even that of Apple AAPL +0.24% or Google GOOG +0.93% etc).

So what is it that the HFT guys are providing to the market? They’re providing liquidity. As Lewis has noted in the New York stock markets they’re just over 50% of all trading right now. So they’re obviously 50% of all the liquidity. Which means that they’re also 50% of what reduces the spread on those markets. And that, in turn, means that everybody buying and or selling stocks has had the tax, that spread, that they must pay reduced by their activity. And while I’ve not got the detailed numbers to prove it I’d be willing to bet a very large sum indeed that the reduction in the spread is greater than whatever amount the HFT guys might be able to make by front running a purchase order from anyone except the very largest of investors trying to move a truly monumental amount of any one stock.

So I’m afraid that Lewis has got this the wrong way around. The HFT guys are making money, yes indeed they are. But they’re making money in much smaller sums than the general investors in aggregate are saving through the collapse in spreads as a result of the extra liqudity. HFT, at least in normal market conditions, benefits the small investor most certainly, not costs her.

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