This week's release of Michael Lewis' new book, Flash Boys, has renewed focus on a little understood area of the market, an area that has garnered the recent attentions of market regulators, New York's Attorney General, and more recently the FBI -- but never as much attention as it garnered from Michael Lewis' interview on 60 Minutes on Sunday, with his book pending release the following day.
Without going into too many specifics, one of the central themes that Lewis discusses is the potential for high frequency traders (or HFTs) to take advantage of certain market information -- like bids and offers -- that are unknown to many other market players.
Defenders of HFTs have come out aggressively, with claims that HFTs increase market activity and liquidity, and have lowered trading costs. The WSJ published an extensive opinion editorial by hedge fund guru Cliff Asness and his colleague Michael Mendelson of AQR, which energetically claims that much of what HFTs do is "make markets" and that they do it best because "their computers are much cheaper than expensive Wall Street traders, and competition forces them to pass most of the savings on to us investors."
Of course this sounds altogether too convincing. Unfortunately, Asness and Mendelson provide little or no evidence (although their business as long term traders relies heavily on evidence, and they claim in the article to spend considerable energies looking into their trading costs) and they admit that they actually don't have too much conviction in the premise of their exposition:
"We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars. We can't be 100% sure. Maybe something other than HFT is responsible for the reduction in costs we've seen since HFT has risen to prominence, like maybe even our own efforts to improve." (emphasis ours)
But this aside, no doubt all forms of HFTs bring liquidity. They're a good thing. Let's focus our attention elsewhere.
Might there be another type of HFT, that doesn't always bring liquidity for the greater good of the market ... perhaps a type that uses obscure mechanisms to change the look and feel of the market -- to make people think there is a bid, think there is an offer, without there being one?
This is what Flash Boys, and the interest it has invigorated in HFTs, really concerns itself with -- understanding market maneuvers like spoofing or pinging: the submission of phantom orders, immediately cancellable, that have the potential to create a false impression of market levels.
Are we creating a whole lot of (potentially fictitious) orders, but not a whole lot of activity? Are there high-frequency non-traders? Are we mis-marking our portfolios as a result? We continue to investigate. But we couldn't help but bring you back to a 2013 chart from Mother Jones, which highlights the growing contrast between actual trades (in orange) and quotes/orders (in red).