There has been a lot of debate recently as to the benefits and costs of high-frequency traders (HFTs). Spurred by Michael Lewis's book, Flash Boys, regulators and market participants are trying to determine if HFTs are good for the markets.
The focus of these debates tends to center on whether HFTs make the markets more "efficient." Do their activities provide additional liquidity, lower trading costs, or increase systemic risk? Is it possible, however, that market "efficiency" is not what we should be evaluating, but rather a bigger, more fundamental question should be addressed.
Let's consider a basic question. Why does the finance industry exist?
Why are we here?
To be a success, businesses must identify a potentially profitable product or service and then find a way to raise the money to make it happen. Likewise, investors must find promising companies in which to invest their hard-earned savings and occasionally find other investors willing to purchase their holdings.
The finance industry was created to solve these challenges. Investment bankers evaluate firms seeking to grow and help raise the capital of those with the best prospects. Research analysts and investment advisors work with investors to evaluate the investment merits of stock and bond offerings. Exchanges create marketplaces for buyers and sellers to cost effectively trade securities.
From these basic activities there have been many improvements in the finance industry over the years. Speculators add liquidity when other long-term buyers (sellers) are scarce. Arbitrage traders ensure long-term investors can trade on any exchange and receive fair value. And the quickness and reliability of electronic trading reduce transaction expenses.
But not every change has been an improvement: We've encountered insiders who trade on non-public material information at the expense of other investors' interests, and advisors and brokers who are improperly influenced by conflicts of interest. Rightly so, these activities have been deemed unfair and are the subject of laws and regulations.
So, as investment professionals and regulators, how should we evaluate whether HFT activities provide a net benefit or loss to society?
As noted, the HFT debate centers around market efficiency -- the shrinkage of the bid/ask spread, the provision of liquidity, faster execution speeds, and so on. Evaluating these components are important, but, if we limit our analysis to these issues, we may miss the more important question, "Do high frequency traders enhance the markets ability to allocate savers' capital to companies with the highest and best use?"
I propose we can evaluate whether HFTs provide a net benefit to society by asking these two questions:
- How does this activity potentially increase the participation of savers in the capital market or increase the efficiency of the allocation of that capital to companies with the best and highest uses?
If it is very hard to find a meaningful answer to this question, then we can assume the activity is most likely a drag on society. Does anyone believe a reduction of 1/4 cent in the bid/ask spread has a meaningful effect on activities of long-term investors or companies raising capital?
- How does this activity potentially disrupt or hinder the participation of savers or the efficient allocation of capital?
In answering this question it would be assumed that a decrease in transparency, an increase in complexity, or activities that seem to favor one group over others would reduce saver participation or potentially misallocate capital. The degree to which an activity is detrimental would vary based on the degree of change. It is important to note the existence of a negative effect does not, in itself, mandate a rejection of the activity. The activity may well provide benefits that are superior to the costs.
Pass or fail?
If we use these questions to guide our evaluation of the activities of HFTs, it seems some activities would fail to meet the test, while others would not. The introduction of various order types which only benefit HFTs would not seem to encourage participation of savers in the capital market or aid in the efficient allocation of capital to companies with the best prospects. At the same time these orders add a significant level of complexity and opaqueness, thus being detrimental to the capital allocation process. Therefore, it is in society's best interest to restrict the number of types of orders.
However, when one considers high frequency arbitrage the analysis could be different. Having the same prices in all markets can increase investors' confidence in the markets and aid in the participation of savers. However, to be permitted, the market structure and processes must be transparent and fair.
Reframe the debate
In conclusion, we need to reframe the debate on HFTs by redefining the metric by which we evaluate their activities. We should no longer evaluate an activity based solely on market efficiency. Rather we should evaluate all activities in light of their impact on the primary objective of the finance industry -- do they, on a net basis, increase the participation of savers and more efficiently allocate capital to companies with the best opportunities? Using this metric will ensure society benefits from all our activities.