HFT (Take 2)

HFT a Black Swan?

My "Take 1" post on high-frequency trading (HFT) referred to a Carl Richards piece in the New York Times which concluded that HFT doesn't have a discernible impact on most investors.  When I had written that post, I hadn't read Lewis's book.  I now have.

From one perspective, HFT is Office Space writ huge with nerds coding various trading strategies (i.e., algorithms) to skim off nickles and dimes on trades.  For the buy-and-hold investor who is re-balancing once or twice a year and is making relatively minor contributions to his or her 401(k), the impact as Richards pointed out is minimal.

When you take into account, though, the enormous trading volume in the capital markets, the sums accruing to the successful HFT firms are huge.  How huge?  Well, some traders fly in their private jets. Routing that reduces signalling by microseconds is worth hundreds of millions.

But to conclude that the small amounts taken from individual trades means that the small investor isn't much affected by the practice may miss a bigger issue that is a theme running throughout Flash Boys. That theme is that very few people understand how the capital markets work - especially since exotic trading has emerged with computers putting on trades, taking off trades, jumping in front of the line to get a probabilistic edge, not to mention so-called "dark pools."

Lewis's readers learn that the regulators were not very helpful in all of this.  In fact, regulators frequently moved to the HFT firms to earn the big bucks - illustrating the phenomena known as "regulatory capture."

So, in my opinion, the fact that the smaller investor isn't much affected and that maybe the whole practice of HFT has some beneficial arbitrage factored in misses a bigger concern.  That is that the whole process isn't understood; and when something isn't understood, the chance of a catastrophe (a "black swan," if you prefer) increases significantly.  For example, (an observation swept under the rug !), the Federal Open Market Committee was totally in the dark about the relationship between the banking system, the housing market, and Wall Street leading up to and into the 2008 crash.

There already have been numerous technological "glitches," as Lewis catalogues, headlined by the infamous 2010 "Flash Crash."  One of the traps that people fall into in today's complex world is that they assume the person flying the plane knows what he or she is doing.  This isn't always the case.