July 10, 2013

The Trading Edge

If stocks trade on moving averages, why do high-frequency firms hire math whizzes?

Providing some form of answer, Thomson Reuters will cease publishing the University of Michigan’s twice-monthly consumer-confidence survey two seconds early to premium data customers including high-speed traders, following pressure from New York attorney general Eric Schneiderman.

Do you have an investment horizon of two seconds? If you don’t, is the early provision of data the problem, or is it a market structure that makes information more valuable if it’s received first?

New York Times writer Nathaniel Popper quoted me in a piece July 8 on the widely publicized controversy. Most everyone said something like, “It’s about time they stopped leaking information to the privileged.”

I said the market had devolved into a footrace. There’s nothing wrong with information asymmetry. Look at the Buttonwood Agreement in 1792 between 24 brokers who formed the NYSE. It set a minimum commission so none would undercut others on price, and required that all give each other preference on trades. Well, isn’t that a first look? Unique and valuable information is the bedrock of capital-formation.

If everyone knows the same thing at the same time, two giant risks develop. First, there is no counter-balancing effect from different reactions at later points. Markets become like sailboats in which all the passengers are on the same side. That’s fine under full sail and will speed you along. But any rogue wave can capsize you.

Second, the market where everyone receives exactly the same thing at the same time – like a starting gun – is a footrace. Regulations require all US stock trades in the national market system to match between the best bid to buy and offer to sell. Orders are prioritized according to the time they arrive – thus why it’s a “time priority” market. Like the 100-meter dash at the Olympics, everyone lines up and the gun sounds and the first one at the tape wins.

Trading firms hire math whizzes to develop statistical models to study which runners are likely to move slightly differently when the gun sounds. Getting information early makes it more profitable. But what should be objectionable isn’t getting information early but that the entire market is forced to accept prices from the fastest participants. Investing isn’t a race, it’s a destination.

Further, think about it. Everyone pays more to get something better. Ever bought a first-class ticket? How about box seats at the arena instead of the bargain rafter version? Should that be outlawed too? Where does it end? Must we all eat the same cereal each morning at the same time?

Investors should be able to compete on different horizons, varying speeds and diverse prices and quantities. If we do that, timing matters much less – and investor-relations and rational thought both become potent again.

You know who could fix this problem? Not regulators, nor attorneys general. Public companies and their investors banding together and demanding that the market no longer be a footrace.

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