Michael Santoli

'Irrational' sense of fairness fuels furor over high-frequency trading

Michael Santoli
Michael Lewis Discusses His New Book, "Flash Boys"
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WASHINGTON, DC - APRIL 04: A copy of "Flash Boys: A Wall Street Revolt" is used to reserve a seat for a discussion with the book's author Michael Lewis, a financial journalist, in the Newsmaker Series of talks at George Washington University on April 4, 2014 in Washington, DC. Lewis's book tells the story of the Canadian banker who uncovered the underhanded and illegal practices carried out by some high-frequency traders on Wall Street. (Photo by T.J. Kirkpatrick/Getty Images)

Any parent knows a surprise treat will draw complaints from the kid with the slightly smaller piece of candy. And grownups love a cheap lunch – unless we think someone else is getting a free one.

It’s an established fact of behavioral research: Even if people are getting a good deal they did nothing to earn, they tend to become indignant when they think others are getting a better one.

This helps explain part of the public’s stance of righteous outrage over high-frequency stock trading practices, which have been thrown into harsh light by the release of Michael Lewis’s book “Flash Boys” and the author’s repeated characterization of the market as “rigged” in favor of these algorithm-wielding middlemen.

Small investors, whether they acknowledge it or not, are tremendous beneficiaries of the cutthroat cyber-jockeying among electronic trading firms. Competition for public orders and a huge investment in the technological plumbing of the markets have given stay-at-home investors $8 commissions and instant trade executions at the best available price for a stock or exchange-traded fund.

Good news for the little guy

In fact, the little guy has it far easier than large institutional investors, who complain that their attempts to buy and sell large chunks of stock are complicated by computer programs made to detect their intentions and step ahead of this expected flow.

The big electronic middlemen compete with hard-to-handle small-investor transactions placed through big online brokers such as Charles Schwab Corp. (SCHW), TD Ameritrade Holding Corp. (AMTD) and E*Trade Financial Corp. (ETFC) to investors' benefit.

They race to intercept these public orders by matching or beating the best available quoted price for the shares. The high-tech sharpies don’t seek to front-run small-investor orders; they try to take the other side of them, because they’re not seen as the first wave of a rush of “smart-money” institutional trades.

This reality was missing from an open letter in which Schwab founder and chairman Chuck Schwab, along with CEO Walter Bettinger, called high frequency trading a “cancer” that “undermines that integrity and causes the market to lose credibility and investors to lose trust.”

Such rhetoric reflects the overwhelming feeling among ordinary investors that they are somehow victims of sneaky hacker-traders abusing the system, when, on balance, they’re getting a pretty good deal.

Interestingly, as the Schwab letter was released, shares of the company and its peers were hit as investors began to worry that the heightened attention on stock-trading mechanics could threaten “payment for order flow” – fees the wholesale firms pay these brokers for the privilege of handling retail trades.

The brokerage firms say this revenue helps keep trading costs low. Richard Repetto, analyst at Sandler O’Neill, says it’s a modest revenue source for the companies and isn’t at all sure to be eliminated. Ameritrade, he says, has claimed that 90% of client trades received some price improvement through this process. Still, it would be ironic if this longstanding practice which seems to help small investors were upended by the same rushed scrutiny the public is now applying to our complex market structure.

This speaks to the deeply ingrained, yet “irrational,” sense of fair play among humans in our society. Behavioral researchers have long conducted an experiment called the Ultimatum Game to prove this tendency. Two subjects are given a sum of money that one of them can decide how to split between them. But both must agree to the split, or else neither gets anything.

An illogical rejection

This work consistently shows that, when the first person proposes to keep more than about 70% of the total and give his counterpart 30% or less, the latter rejects the deal at a pretty high rate. This rejection is seen as irrational, because the principle of pure self-interest would suggest that accepting any sum of money, no matter how small, is better than getting none at all.

(Such a sense of fairness seems culturally based, prevailing in modern Western societies more than those that have a dominant “gifting” ethic, and it seems particularly fundamental to business and financial dealings in capitalism.)

The most off-putting games pure HFT trading firms play is to pay for a privileged early glimpse at public quotes, and to exploit certain complex order types to skim small profits from detecting related patterns. This is the kind of questionable activity that rightly is under scrutiny by investigators and regulators, but probably represents a limited component of what we now call HFT.

This sort of gamesmanship understandably ticks off Main Street, especially when they are informed of such years-old practices in the style of a “gotcha” expose on “60 Minutes.” 

Polls following a pro-versus-con HFT debate on CNBC last week showed viewers overwhelmingly believed the anti-HFT guest was right, despite the fact that the discussion was over an obscure gray area of financial technology and both sides aired valid points. The idea that someone is gaining an unfair advantage – even one that is trivial relative to the benefits hyper-fast markets deliver average investors – is powerful and durable.

One common charge is that small investors are indeed hurt because they are the ultimate investors in large pension and mutual funds, which must contend with HFT parasites. True, but even here the total profits of HFT speculators have declined sharply in recent years, and the frictional costs of trading among the HFT ‘bots are dwarfed by the basic expenses of running a fund (and the lush profits collected by asset managers out of management fees).

Middlemen have always profited from fund traders’ orders – only it used to be more in the form of heavier commissions and wide bid-ask spreads on stocks. Now it comes in much smaller, if more irritating, bites from trading algorithms, at far lower overall cost to funds. It's simply unclear how much of this broad cost reduction would be reversed if new rules drained away the narrow "skim" that hyperactive electronic market makers collect.

Of course, small investors these days are abidingly suspicious of Wall Street and the financial industry in general, even five years after the financial meltdown. This certainly has plenty to do with the uproar in recent weeks.

Want some evidence, though, that HFT isn’t poaching cash from Mom and Pop retirement accounts in large amounts? The Vanguard Group, the mutually owned index-fund manager of $2 trillion that's always been fanatical about keeping investor costs to a minimum, has made its peace with HFT.

In a statement the company said: “We believe the majority of 'high-frequency traders' play within the rules governing our current equity markets. We believe a majority of 'high-frequency traders,' which is not a defined term, add value to our current structure by 'knitting' together today's fragmented market centers.”

This, mind you, is a firm that delivers the small investor the entirety of the U.S. stock market for a mere 0.05% of assets a year, through the Vanguard Total Stock Market exchange-traded fund (VTI). It’s truly irrational for an investor with access to such a product to get too worked up into a victim complex about the games of “spy versus spy” played by dueling sets of software deep in the financial markets.

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