Are you frightened of high-frequency trading (HFT)? Are you concerned about what it might do to your stock portfolio?

If so, you may have been exposed to Michael Lewis over the past few months. It’s been hard not to be, especially if you watch financial shows on TV or read the financial press. He’s been everywhere, giving interviews and promoting his blockbuster new book, Flash Boys: A Wall Street Revolt.

But is he right?

Lewis’ premise: the advent of HFT means that stock markets are now “rigged for the benefit of insiders,” as the book’s jacket flap notes inform us. And if that’s not frightening enough, it goes on to state, “The light that Lewis shines into the darkest corners of the financial world may not be good for your blood pressure, because if you have any contact with the market, even a retirement account, this story is happening to you.”

That’s great copy, isn’t it? Any good publisher understands that the easiest way to get people’s attention is to scare the crap out of them. Notions of shadowy conspiracies also work. And who wouldn’t want to know what’s going on in those darkest corners of the financial world?

Problem is, we’re already aware of what’s been happening in Wall Street’s figurative back rooms. We’ve been exposed to many of the big banks’ secrets, such as that many of them profited enormously from the crash of ‘08 by making huge bets against the very junk mortgage securities they were simultaneously promoting to their clients. Compared to that level of darkness, high-frequency trading is a sunny day in June.

But Michael Lewis delves into some important issues. Central among them is a pair of questions. Are the markets “rigged?” And if so, should we be concerned? I would answer yes and yes, but not for the reasons Lewis advances in his book.

The New Normal

Maybe someone without access to media of any kind might still believe that markets aren’t rigged, but the rest of us know that they are. The interest rate market, for example, is completely rigged by definition, since our central bank manipulates the cost of money at its whim.

With gold, the market is small enough that traders with sufficiently deep pockets, like the biggest banks, can push prices up or down to their hearts’ content.

With stocks, prices are sometimes rigged openly, such as when Washington prohibited short sales during the meltdown… and sometimes more subtly, as when the Fed buoys prices by pushing trillions in funny money into the system. The giant investment banks employ any number of shady tricks, such as arranging large transactions inside their “dark pools”—where buyers and sellers can connect directly and not affect the public stock price by going through an exchange. And there are always the market makers. As middlemen, their job is to provide liquidity, which they do by rigging the bid/ask spread (in such a way as to ensure profits for themselves, of course). They’ve been known to widen those spreads unjustifiably, and no one ever says, “Hey, wait a minute…”.

These are all concerns, sure, but they aren’t what Lewis writes about. His focus is on high-frequency traders, what they do, and why it’s so evil.

One of the bothersome things about the book is that Lewis presents his research with a “Wow, look at this mind-boggling secret I just uncovered” approach. And TV’s talking heads have largely gone along with him, expressing their shock. But we’ve known all about HFT for a long time. In fact, I wrote an article for Casey Extraordinary Technology that explained it 2.5 years ago, and since then both Alex Daley and I have expanded on the subject in this space.

Let’s be clear: no one completely understands what HFT is doing to the markets. While a human high-frequency trader may have a general idea of what his algorithm is up to—though even that is in question as advanced forms of artificial intelligence (AI) are now used to let the computer dynamically make up new rules regarding how to trade—that doesn’t mean he knows the net effect of its actions. With thousands of systems battling against each other, making millions of trades, it quickly becomes obvious that people are on the outside looking in—pretty ignorant of what these arrays of supercomputers are cooking up on their own at any given moment.

http://www.caseyresearch.com/cdd/how-i-learned-to-stop-worrying-and-love-high-frequency-trading

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