“The price system is just one of those formations which man has learned to use (though he is still very far from having learned to make the best use of it) after he had stumbled upon it without understanding it. Through it not only a division of labor but also a coordinated utilization of resources based on an equally divided knowledge has become possible.”
Friedrich Hayek, The Use of Knowledge in Society
After the sharp plunge in U.S. 10-year Treasury yields on the morning of October 15, 2015, Bob sent us a few articles which blamed the quick v-shaped price movement on the new breed of algorithmic traders often referred to as High-Frequency Traders (HFTs). The robots were at it again. They were scraping headlines; focused on speed and execution; artificially pricing the Treasury market. A herd mentality amongst the machines was blamed to which Geoff replied, “Why doesn’t someone write an algorithm to arbitrage algorithmic trading, and what do these people mean by artificial pricing?”
How Is Pricing Artificial?Price is a social language, universal in scope, created by capital backed by information derived from a multitude of market participants. Today, we hear the term “artificial pricing” thrown around as if it made sense. What is price if not the synthesis of human and computer information that informs multiple levels of bids and asks to create a very tight spread of indeterminacy? The indeterminate spread has tightened over the years with the influx of algorithmic trading, the increase in bandwidth and processing power, the number of market participants, decimalization, and competition within the marketplace. While we are not loyal to the Efficient Market Hypothesis, we do hypothesize that the market is becoming more efficient. Just because an entity like the U.S. Federal Reserve creates a science experiment out of the economy, are we to call present pricing “artificial?”
Anytime there is increased volatility in the markets, we hear about the other source of artificial pricing—algorithmic trading. Along with its newer and disruptive kin, the HFT firm, the algorithmic trader is blamed for a market that appears dysfunctional. As we examine the new targets of market volatility, we ask the rhetorical question: In a period of uncertain information, does efficient pricing imply stability?
HFTs – A Monolithic Industry? HFT firms are vilified to a point that most high-speed electronic traders are amalgamated in public thought as a single entity. It was only Brad Katsuyama and his IEX alternative trading system, which managed to separate itself from HFT denigration by forcibly slowing down information and execution in a unified dark pool (private exchange system). The intent is to crowd out the nefarious dark pools to create an equitable dark pool where information advantage is leveled through increased latency (i.e. delay). The argument is to keep competitive pricing within a monopolized exchange, eschewing price discovery through competitive exchanges and alternative trading systems as unnecessary and possibly predatory.
Decimalization and Disruption. Many investors may recall that before the 1990s, equities were priced in fractional increments. Before the 1990s, the most accurate price quote for a given equity was at 1/8 of a dollar (i.e. $0.125). Through the decade, the SEC pushed exchanges to accept smaller tick increments of 1/16 ($0.0625) and 1/32 ($0.03125). On April 9, 2001, the SEC forced decimal trading (decimalization) on all exchanges ($0.01). With decimalization, pricing became more precise.
However, decimalization has been charged since inception as allowing price manipulation, decreasing market liquidity, and increasing volatility. Another argument against decimalization is that reduced bid and ask spreads reduced profits for market makers, which would theoretically dry up liquidity as less capital would be attracted to a lower margin function. Today, some of the most vocal opponents of HFT firms are institutional traders and traditional market makers who are seeing their margins evaporate due to a disruptive business. We are told that HFT firms are manipulating prices, decreasing market liquidity, increasing volatility, and disrupting traditional market making functions. So much for decimalization…
Slower Is Better? Once in a while it is useful to step back from financial examples to illustrate financial concepts. Here we would like to talk about Netflix. Netflix has been at the center of the debate of net neutrality (a fundamental debate about the relationship between content providers and internet service providers). In essence, Netflix does not want to pay-to-play for its bandwidth. They argue that all traffic must be treated equitably. However, the pay-to-play tax is already coming to new subscribers who want the newest iteration of “high-definition”. Higher definition video requires more bandwidth, so more information has to be sent very quickly to the Netflix consumer.
If we take the argument of creating a unified playing field to the level of Netflix, we may be able to see how this plays out. Netflix is currently the top internet video platform in terms of bandwidth. If Netflix were forced to pay-to-play (i.e. if they must pay service providers to stream their services), they would need to tier their service to meet the demands of the ultra-high definition consumers, while still providing a service for those who just want to watch a television show regardless of quality. The customer simply wanting to watch a TV show on her phone may not want to pay for the same plan as someone watching Netflix through a home theatre system. Therefore, tiers are created.
If tiers were not created and Netflix forced everyone onto an average pricing system and doled out the same quality video, we would all be equal in our ability to watch low definition content. IEX, the celebrated non-HFT firm, wishes to slow execution and information on an equitable basis for everyone. With HFT collocation (The ability of broker-dealers to utilize HFT pricing and execution on behalf of their clients), the pay-to-play fears are abated, while allowing for a more efficient pricing mechanism. While there are charges—especially from institutional trading desks—of front running and skimming, we must ask ourselves if we want exchanges to continue operating in standard definition or whether it’s time for HD.
Front-Running and Skimming. We noted in the last section that HFTs are taking the traditional place of equity market makers who buy and sell shares of stock to firm up bid and ask spreads. Similar to market makers of the past, HFT firms are now being accused of front-running and skimming trades. We do not doubt there are bad people out there looking to create unfair advantages. Should the entire concept of high-frequency trading be prejudicially nullified because it can be used for nefarious purposes? Should this practice be suppressed by artificially slowing down information, or perhaps, can it be leveled through the continuation of innovation, competition, and eventual commoditization—the forces enabled through capitalism? Anyone who believes that skimming or front running are new phenomena in the function of market making has a much higher opinion of the ethical integrity of the people fulfilling this function in the past than we do.
Every time a disruptive practice enters the trading arena, it has the potential to create flights of frenzy within the investing public. We believe disruption is essential for the growth of free enterprise and capitalism. While we do not discount the idea that disruptive business can be predatory, we do not believe that this is cause to hamper innovation:
“The problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them. As long as this is not recognized, the investigator does a meaningless job. As soon as it is recognized, his outlook on capitalist practice and its social results changes considerably.” - Joseph Schumpeter, Capitalism, Socialism, and Democracy
Some will charge that we are ignoring the severe front running that is active within the dark pools operated by HFT firms. The reason that disruptive practice creates flights of frenzy is because it is new, and as with most technological innovations, the possibility for abuse is real. We believe that continued competition and innovation will force the marginal utility of certain questionable HFT business practices to diminish over time. Businesses will also innovate in the manner of IEX by trying to bring light to these dark pools. While we disagree with the concept of slowing information to compensate for aging systems at the exchange level, we do recognize the disruption in the HFT industry, from which IEX not only created, but profited.
Creative destruction is the soothing balm of capitalism. Inefficient and predatory business practices will be priced out of the market once they have viable competition. If HFT truly brings liquidity and more efficient pricing to the market, then the market needs to allow for enhanced competition to proliferate and democratize its processes. If it only creates opportunity for front running, then it should quickly price itself out of the market. As Ted stated after reading a preliminary draft of our article, “I’m all for liquidity, and it’s clear that the market outgrew the old fashioned boys’ club system a long time ago. I just hate the chiselers.” We agree.
