Market Electrolysis

Have you seen those Pure Michigan ads? Compelling. Summer in Colorado could be a brand too, as these views of Hanging Lake near Glenwood Springs and Vail at morning last week attest. We seize every chance to savor the high country.

Speaking of chance, high-frequency trading (HFT) is back in the news. When you read about HFT in the financial press, it refers to stock orders from proprietary traders (firms using their own money rather than executing orders for customers) using powerful machines to trade in fractions of seconds.

But that description propagates an incorrect perception of what’s happening. It’s a vision of anonymous and rapacious rapscallions hiding behind banks of computers and cackling evilly while out-sprinting hapless investors from trade to trade, looting financial markets.

The truth is simpler and less execrable. Investor relations pros, you need to understand not just what HFT is, but why it exists and what’s both good and bad about it.

I was just reading a blog post by John Tamny extolling the virtues of HFT. Mr. Tamny is a regular commentator on TV financial programs, a free-market kind of guy. I routinely encounter folks opposed to “banning” HFT because it’s free-market behavior.

On the other side are commentators who revile HFT as proof of free markets run amok. It’s just silly romanticism to suppose “the market” can regulate itself. We’ve got all these traders with unfair advantages exploiting innocents and pillaging Grandma’s mutual funds. We should ban that stuff.

So who’s right?

Let’s get to what HFT is, why it exists and what’s good and bad, and see if that gives us the answer. First, HFT is arbitrage, a buy- low/sell-high scheme requiring more than one security. It’s also a by-product, a derivative of something else. You know you drink hydrogen and oxygen every day? Through electrolysis, one can separate the two oxygen molecules in water from water’s single hydrogen molecule, creating byproducts.

The SEC created HFT. It’s a by-product of rules and market-participation. Regulators split brokers from the exchanges brokers had established and operated for decades, forcing Siamese twins to compete. Regulators also decimalized trades to break up the brokerage cartel, forced slow markets to display prices from fast markets (the Order Handling Rules), compelled competing markets to connect electronically, required orders to buy and sell to be computerized for electronic display in all other markets, and decreed that trades occur at or between the best bid to buy or offer to sell. The electrolysis of the markets, one might say.

Those were not choices made by the market’s participants. Public companies, participants whose shares would continue to trade in it, were never even consulted. When the switch was flipped so to speak, volume exploded as ever-faster computers raced to set prices.

This process of moving tiny bits of liquidity from one market to another at very high speeds became an end unto itself. HFT. Now everyone is doing it, because it’s the least risky form of investment. Why? Because it requires little capital commitment to invest for 30 milliseconds, with equal and offsetting market positions that pin real value-at-risk near zero at all times. Remember, HFT is arbitrage – constant and continuous offsetting trades.

Should that behavior be banned? That’s like telling everyone to stand up and then fining anyone who’s not sitting down. The behavior is the result of rules. How about removing the rules that created it? What would we get? Brokerage cartels and separate markets – and maybe 500 IPOs a year again. That’s a lot of IR jobs.

Is HFT free-market behavior? No, it’s rigged behavior. It’s like setting up a decathlon competition but only awarding points for high jumps. High-jumpers would always win, just like HFT. The rules best suit HFT, so that behavior dominates.

What’s good about HFT? It stabilizes the digital network. So long as there are no power surges or outages, so to speak, it clings together despite unbelievable price-volatility. If your stock trades 100,000 times a day, in a month that’s theoretically two million price points. We track cumulative price-change every month. It’s an astonishing 40% marketwide. But on the surface, below those fractions of seconds where HFT resides, you don’t see it.

What would be better? Well, 500 IPOs a year, and a market where somebody besides high-jumpers could win. Forcing all behavior around a single measuring stick will inevitably migrate a market to its lowest common denominator.

And that’s what HFT is. The lowest common denominator of your stock’s value. But HFT in fractions of seconds gets to set the price for all your investors, including the ones you’ve had for years. In this second or that, it can be great. But you just never know.

Does that seem right?