You’re probably hearing a lot about high-frequency trading today. HFT is the subject of Michael Lewis’s new book, Flash Boys, and Lewis books being the weapons-grade attention-grabbers they are, the topic is sure to come up at cocktail parties up and down the Acela corridor. Lewis’s conclusion about the effects of HFT on the public markets is fairly simple: "Stock market’s rigged," he told CBS’s Steve Kroft, on last night’s "60 Minutes."
But how big a deal is HFT, really? And does it rise to the level of something the average stock-market investor should care about?
First, let’s stipulate that “average stock-market investor” is itself a subset of the general population. Only about 52 percent of Americans own any stock at all, even when you include the stocks contained in 401(k) plans or mutual funds. Of the stocks owned by those 52 percent, only a portion are being actively managed, either by the stock owners themselves or through a broker or fund-manager. The rest aren’t changing hands every day, or even every year.
Another way to frame Lewis’s “stock market’s rigged” thesis is this: High-frequency traders have conspired to impose a speed tax on investors. This tax is taken from the pockets of people who buy and sell stocks and put them into the pockets of the HFT firms, and it’s volume-based. Trade only a few stocks a year, and your tax is small – fractions of pennies, perhaps. Trade millions of shares every day, and you’ll end up paying much more.
How small is the speed tax? A 2013 study examined blocks of trades coming through HFT firms and estimated that “HFTs’ have revenues of approximately $0.43 per $10,000 traded.” In other words, the net loss to the average, small-time investor from HFT is probably very minimal. (In fact, given what preceded HFT – a set of firms known as “NYSE Specialists” who were given preferential access to stock trades in exchange for providing liquidity – the HFT speed tax may be a lot lower than what most normal investors used to pay.)
This explains why the biggest backers of IEX, the playing-field-leveling exchange Lewis writes about in Flash Boys, are large hedge-fund managers and financial institutions. Retirees in Kansas don’t trade stocks often enough for all those penny fractions to add up to much. But David Einhorn trades at such a large volume that his extra costs are real. For him, HFT’s profit-skimming isn’t a theoretical outrage; it comes off his bottom line every day.
Lewis argues that HFT does hurt the average American, even if the actual amounts involved are negligible to most individual investors. In the conclusion to Flash Boys, he writes:
One obvious cost is the instability introduced into the system when its primary goal is no longer stability but speed. Another is the incalculable billions collected by financial intermediaries. That money is a tax on investment, paid for by the economy; and the more that productive enterprise must pay for capital, the less productive enterprise there will be.
Another cost, harder to measure, was the influence all this money exerted, not just on the political process but on people’s decisions about what to do with their lives. The more money to be made gaming the financial markets, the more people would decide they were put on earth to game the financial markets — and create romantic narratives to explain to themselves why a life spent gaming the financial markets is a purposeful life.
Of these three arguments, Nos. 1 and 3 are the most compelling. Market stability in the HFT era is an issue – as various “flash crashes” over the last few years have demonstrated. And it is a tragedy that math and computer-science geniuses are being wooed into high-frequency trading shops rather than putting their skills to use elsewhere in the economy.
But when it comes to Lewis’s second argument – the financial costs of HFT – the costs are much less clear. It’s true that hedge-fund and mutual-fund managers invest on behalf of pensioners and retirees, and that the losses they take as a result of HFT are passed along. But to the average person, those losses would be so small as to be barely noticeable. And while pensions and other large investors are understandably upset about certain HFT practices (like quote-stuffing and latency arbitrage), they tend to acknowledge that high-frequency trading, as a general category of financial innovation, has done them more good than harm.
Michael Lewis is a genius, and his book will give high-frequency trading a much-needed turn under the microscope. But even HFT skeptics admit that the practice probably isn’t making a dent in the personal finances of normal people. For the average investor with a Vanguard 401(k) or a state teacher’s pension, tweaking a portfolio to include more low-cost index funds is probably a better use of time than fretting about losing money to algorithms.