Not Instantly

The Chickens Are Coming Home to Roost on High-Frequency Stock Trading

Sometimes I hear two seemingly unrelated news stories reported back-to-back in which the latter seems to answer the questions raised by the former.  That happened just the other night while listening to All Things Considered on NPR.

The first story was about high-frequency stock trading.  The new book Flash Boys, by Michael Lewis, attempts to show how high-speed trading on many exchanges are allowing a few large banks and investment firms to gain a legal but unscrupulous advantage.  It chronicles the story of Brad Katsuyama, a trader at the Royal Bank of Canada, who first noticed and then began to wonder why his stock trades were always completed for a price higher than the one just quoted.

Stealing is stealing.

It turns out that certain big high-frequency trading firms were using their ultra-fast servers – often with special access to the exchanges – to probe for information about who was trading what.  Identifying a sale about to happen, the high-speed traders swoop in, buy the stock in question, and then immediately sell it back to the original buyer for a slightly higher price.  Each sale only brought pennies in profits but volume turned that into hundreds of millions of dollars (or more) in a year.

Wall Street is divided in its reactions to the book.  Defenders of high-speed trading concede that Lewis exposes genuine shortcomings but insist he hyperbolizes both the extent of questionable practices and their impact on markets.

Katsuyama and a team of technicians he organized have figured out a way to neutralize the advantage of high-frequency stock traders opened a new exchange of their own.  As NPR reports, investment firms like T. Rowe Price and Goldman Sachs are now routing some of their stock trades through this new exchange.  So are “famously smart investors like David Einhorn and William Ackman.”

“The stock market is rigged,” Lewis accuses.  “It's rigged for the benefit of a handful of insiders.”  That characterization was aggressively disputed by Bill O’Brien, the President of rival exchange operator Bats Global Markets Inc. when he appeared on a CNBC interview with Katsuyama.  Others think Lewis is right on the money.

Investment giant Charles Swab just issued a press announcement denouncing high-frequency traders for “gaming the system.”  Schwab called the practice “a growing cancer” that needs addressing.  In a Financial Times profile, a Sachs Goldman insider was quoted as saying, “At some point in time the chickens are going to come home to roost on the HFT game.”

This story was immediately followed on All Things Considered by a story about former wedding planner turned etiquette consultant, Jeanne Hamilton.  She has created a website, entitled Etiquette Hell, for people whose bad behavior runs beyond the pale.  Hamilton says the number one etiquette violation reported by office workers is fridge theft – people have food they have prepared and left clearly marked in the communal refrigerator stolen from them constantly.

The problem is compounded when the thief is not a peer but a superior.  Hamilton relates one story told to her in which the thief was a company’s CEO.  This person not only stole food but was brazen about it.  In one case, the CEO reached down and sampled the lunch off a subordinate’s desk as he stood talking to them.  In another, his food sampling passed along a virus to others.

When asked why some business people would act so unethically, Hamilton speculates confusion over communal fridges with communal food.  She also considers misplaced good intentions, in which the theft takes food planning only to borrow it but then never pays it back.  In the end, “she speculates the real issue is that some people have an incredible sense of entitlement.”

This may well be the answer behind high-frequency trading abuses too.  Its proponents insist that most high-speed traders “are ethical and following the rules and doing the right thing.”  They cite numerous benefits that high-speed trading brings to markets, including price liquidity and efficiency, that overall mean lower prices for (small) investors.  As Philip Delves Broughton, author of The Art of the Sale – Learning From the Masters About the Business of Life, points out in a New York Times op-ed piece, “It makes sense to monitor it, as one should any innovation. But it would be a shame to silence it.”

It may be that fees as well as other penalties and restrictions can gain some control the problem.  Yet  the inhabitants of the comic strip Dibert know that stealing is stealing, even if it takes place in the shadow of high tech.  That is why I agree with Charles Schwab’s pronouncement, “But if the practice is simply a scam, as we believe it is, an even better solution is to simply make it illegal.”

I am no technophobe and computers have helped organize the hectic world of stock markets as they have almost all other aspects of modern life.  Yet in this case, the argument seems to be we will achieve better control by speeding things up.  All sorts of crazy phenomenon happen when you approach the speed of light – as we are rapidly doing in computer hardware – and these make it all too easy to hide skullduggery.  Stock trading needs to be conducted fairly, not instantly.

I mean, if we know some CEOs literally are willing to steal food out of our mouths, it begs the question as to what else they are capable.  Now we know.  Thanks Michael Lewis.