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It Ain't Rocket Surgery: The Skewed Incentives and Dangerous Consequences of High-Frequency Trading

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During my appearance on NPR's Marketplace last week, I discussed why I left the high-frequency trading (HFT) business. When I learned that I was about to become a father, I was forced to re-examine many things in my life, not the least of which was a profession that added little value to the world. At 30 years old, I would regularly be trading positions worth millions of dollars, an extremely stressful daily undertaking. I began to fear that I was spending too much of my life's stress budget on something that quite honestly, was helping to wreak tremendous economic havoc. Ultimately I decided to walk away from an extremely lucrative profession.

HFT is a subset of a part of the financial services industry called quantitative analysis. Researchers are often referred to as quants, and there's a popular saying amongst quants: "It Ain't Rocket Surgery." This conflates "rocket science" and "brain surgery" to come up with a hybrid term that is supposed to poke fun at the fact that while what they do is very hard, it wasn't as hard as either of those.

Lately, I've thought about this saying in a different way. The most successful quants make huge amounts of money -- annual bonuses in the millions of dollars. Quants who have proven themselves successful (or who just sound really smart and interview really well) can command base salaries very similar to top neurosurgeons, and without the 15 to 20 years it takes to advance in said profession. While working at one of the largest hedge funds in the world, I heard the story of a quant manager who was so offended by his meager $85 million bonus that he left the company. I'm not sure there's an aerospace engineer or neurosurgeon or even a Major League Baseball player in the world that wouldn't happily take this bonus.

I wouldn't argue that compensation in HFT is dramatically different than in the rest of financial services, but it is certainly among the most extreme in the industry.

This would all be well and good if high-frequency traders contributed some value to society at large. Examining the value proposition (or lack thereof) of HFT would take many blog posts, or an entire book (which was just published, Broken Markets by Sal Arnuk and Joe Saluzzi). There is a case to be made that rather than providing liquidity and increasing market efficiency, HFT is doing the opposite (Nanex has produced some excellent research on this topic).

I have personally seen how HFT is increasing market volatility, creating events such as the Flash Crash of May 2010. I was on the trading floor when the market disappeared that day, and stopped functioning. While the standard explanation of the flash crash is an order that was too big for the market to handle, it had seemed inevitable that Chaos Theory and the nonlinear implications of sensitive dependence on initial conditions would lead to a destructive positive feedback loop. In other words, a butterfly flapped its wings somewhere in Delaware, and the entire U.S. equity market fell apart for a few minutes. Nothing has changed since then, and individual securities demonstrate this behavior on a daily basis.

There is no doubt that the fallout of the Flash Crash is that retail investor confidence has been undermined, and small investors have been fleeing equity markets even as the economy flattens out and the market rises. According to the Wall St Journal, "$370 billion has been withdrawn from U.S. stock funds by small investors" since this event. Some argue that equity outflows are a result of the worst financial crisis since the Great Depression. However, the stock market has risen by almost 19 percent in the two years following the Flash Crash (though there was a month -- from July to August 2010 -- during which the market dropped more than 16 percent). With this kind of volatility, is it any wonder that retail investors are fleeing from a market that they no longer understand?

There are much graver implications to our economy from increased market volatility and decreased investor confidence. Higher volatility creates a negative wealth effect. Retail investors tend to time the market poorly, buying when stocks are too high and selling when they are too low. In addition, higher correlation amongst stocks means that traditionally unrelated companies and sectors move in a more concerted fashion. This eliminates the benefits of diversification, an idea that has been championed to retail investors for decades. As retail investors pull out of the market, the bedrock of the greatest capital formation and price discovery mechanism ever created is disappearing, leaving behind statistically-driven trading systems trying to game each other to shave pennies here and there. This is destroying the U.S. economy's ability to support and grow new businesses.

I entered the world of finance for many reasons. I grew up during the dot-com bubble, so I thought I knew how to pick stocks. The compensation was extremely high. There's also huge appeal to "the game," the relentless judgment passed by the market on a daily basis demonstrating how right or wrong you are. But at my core, I have philosophically been a capitalist my entire life. As I witnessed the destruction of capital markets, driven by crony capitalism and the ambition of a small wealthy population to become yet wealthier, I could no longer sit idly by and watch it happen. Something must be done to dramatically shake up the financial services industry, and while regulations are being written and manipulated by lobbyists, that will not happen. In my next post, I'll talk about some possible solutions to this problem, and why we have little hope of seeing them passed without several more crashes, flash or otherwise.