High Frequency Traders Make The Markets Much More Liquid, Transparent, And Fair Jul 16th 2013, 16:00
Image via CrunchBase
Several years ago, when 'high frequency' trading first captured the imagination of the commentariat, I was on a radio show panel on which the health of the stock market was discussed. One participant, a fairly well known columnist for a major market publication, opined that the existence of computerized, high speed trading was a barrier to the retail investor returning to the market and boosting it.
As one can imagine, 'fairness' was brought up. Supposedly the ability of some market participants to complete trades at lightning speed, sometimes with privileged information purchased from providers of same, was scaring away the little guy from what was surely a 'rigged' market. When the 'flash crash' revealed itself not long after, market scolds rejoiced as though a quickly fixed error somehow indicated a need to rid the marketplace of new sources of liquidity.
To paraphrase the great P.J. O'Rourke, we better hope the stock markets never become fair. Indeed, if you're reading this article odds are you either grew up in the U.S., or another reasonably developed country. Is that fair? It's probably not, but it would be rather foolhardy if the U.S. sought to shed its advantages over other countries in order to create a 'level playing field.' To some it's probably not fair that a select few fly up front on airplanes, but absent the willingness of the outliers to sometimes pay handsome sums to fly comfortably, there would be no supersaver fares and no trips to London for the bargain shopper. Put simply, life would be very cruel if it were more fair. Think Soviet-era Russia.
Looking at the stock market, it's thankfully not fair despite the wishes of so many to make it so. Since there's lots of money to be made there will as a result always be participants who have better information than others. The witless among us decry the access of an information edge, or 'inside' information, but what would be really scary is if the markets were blinded to the information brought to them by the ambitious and intrepid. Thank goodness markets aren't fair, though opportunists of the political variety are desperately seeking to make them more level – to the detriment of the small investor.
This revealed itself most recently with the settlement between Thomson Reuters Thomson Reuters and New York attorney general, Eric Schneiderman. In the past Thomson Reuters has sold to paying clients two second advance knowledge of its University of Michigan Consumer Sentiment Index (the Wall Street Journal's L. Gordon Crovitz helpfully points out that the sale of the research pays for the very report much desired by the markets) results. Such results have a tendency to move markets, and two seconds was and is enough time for high-frequency traders to place trades ahead of the overall market.
As James Stewart of the New York Times has noted, a year ago, and thanks to the advance sale of this information, "200,000 shares traded during that 10-millisecond period" ahead of the release of consumer sentiment numbers, but last Friday "trading was all but 'nonexistent.'" You see, it was deemed 'unfair' by Schneiderman that some market participants acted on information not broadly available to the marketplace. In truth, Schneiderman's actions will make the markets much hospitable to the little guy.
Implicit in the hand wringing about the use of non-public information or information for sale is that access to same is a one-way street to trading profits. That's a nice thought, but also utterly nonsensical.
Indeed, forgotten by the emotional advocates of 'market fairness' is that there are always two sides to every trade. For a high-frequency trader to purchase shares of Google Google, Cisco and Facebook Facebook there must be someone willing to sell based on an opposing view of the technology giants.
To read mainstream market commentary is to assume an unlevel playing field marked by information-savvy operators minting profits based on knowledge unavailable to others. If true the latter would be fine given the tautology that information is a huge economic input, but it's not how things work. For there to be a buyer there must be a seller, and vice versa. When information-armed participants transact, they're only able to do so insofar as others with the same information disagree with them; that or others are willing to voluntarily transact even without the supposed luxury of superior information.
Importantly, the small investor gains for large institutions making the initial risky leap into the marketplace based on non-public or expensive information. That's the case because as evidenced by the existence of a deep market for buyers and sellers ahead of information going public, there's clearly a wide variety of views as to what the information will mean for the economy and markets. A deep marketplace of players willing to bet large sums based on opposing views speaks to a market composed of smart money not sure which way stocks, bonds and all manner of securities will go once the news is public.
Happily for the small investor, high frequency traders are once again willing to risk large sums of money despite not knowing for certain which way the markets will tilt. The latter means that the small investor does not have to risk his or her capital on what's unknown. Instead, the small investor can enter the market after the fact, after the dust has in a sense settled. Put plainly, the small investor is able to enter a market that's more fair for it having already priced risky information that the smart money plainly didn't agree on.
Importantly, it gets even better for the small investor. Thanks to high frequency and large investors digesting news for everyone else, a more informed market is more likely, not less, to attract new entrants. Just as the buyer of the first class ticket to London makes it possible for the budget traveler to reach Heathrow just as quickly, large, intrepid market participants create a better, more informed, more liquid market for everyone else.
Looking at efforts to ban the use of information by sophisticated investors, such actions will ultimately make the markets less transparent, less liquid, and less fair. As is so often the case, in their zeal to make markets fair, highly emotional commentators and politicians are achieving the opposite.
YOUR COMMENT
