Hillary Clinton has recently attacked high-frequency traders. In response, some scholars have agreed with my position that Mrs. Clinton's policy is off-base. Some say this is by design. Only Matthew Yglesias believes it is her "wonkish best".
Let's assume, for just a moment, Mrs. Clinton is interested in regulating high-frequency traders, but has simply missed the mark. If we hope to properly regulate these traders, there are two preliminary questions we should answer. The first is how they came to occupy an important place in our market structure. The second question is whether they are delivering value to our society. The answers to these questions may be awkward for Mrs. Clinton.
The Rise of High-Frequency Traders
Those who have studied high-frequency traders, including Scott Patterson in Dark Pools, have traced the origins to two sources. The first is the rise of "quants" who "compose complex mathematical models to detect investment opportunities." Among the first was Ed Thorp, who wrote Beat the Market: A Scientific Stock Market System in 1967. On the heels of Thorp's publication, the first quants began to explore computer-based trading.
The computers used by quants could recognize opportunities and send signals faster than any human. However, quants found that mandatory human involvement in all trades caused friction within their theoretically perfect systems. The NASDAQ market makers and NYSE specialists, the liquidity-maintaining middle men in their respective markets, had the ability to slow trading and ignore disfavored traders altogether. It would take more than the emergence of quants for high-frequency trading to become a powerful force in the markets.
What ultimately allowed high-frequency traders to overtake humans was the maddening imperfection of the humans who occupied the market structure. This was seen in two high-profile scandals. The first was on Black Monday in 1987. On that day, market makers selectively answered their phones or refused to answer altogether during a then-unprecedented one-day crash. This moment lives on in market lore as well as pop culture, earning a reference in The Wolf of Wall Street.
The second was a 1994 paper by Bill Christie and Paul Schultz indicating that market makers were colluding to create artificially high trading costs. The Clinton administration's Department of Justice found millions of investors were victims of "anticompetitive conduct which results in higher trading costs." Years later, Scott Patterson wrote in Dark Pools that "NASDAQ's market makers were siphoning billions from investors by keeping spreads never less than a quarter. The Clinton administration concluded that significant changes are in order.
Those changes injected competition to the market structure. First, new exchanges could open with just $1 Million in capital. Second, markets were forced to route orders to the venues where they would get the best execution. Nearly two decades later, a NASDAQ Vice President would acknowledge these reforms, "greatly democratized the markets."
Once the new exchanges were established, there was a frenzy to attract liquidity. They attracted high-frequency traders by instituting the maker-taker rebate system. Just like that, the specialists and market makers who had served vital roles in the markets were displaced. Into the role "stepped the speed traders... the new market makers of the digital age."
The inquiry into the origins of high-frequency traders reveals Mrs. Clinton is embarrassingly wrong on the subject. She claims high-frequency trading arose because "the Bush administration and Republicans in Congress largely ignored calls for reform." In fact, it was purposefully elevated while she lived in the White House.
High-Frequency Trading Today
Having traced their origins to Clinton era deregulation, the next question is whether high-frequency traders are good for our markets. Readers of Michael Lewis' best-selling book Flash Boys know high-frequency traders can abuse the market structure. A problem arises, however, when one accepts Mr. Lewis' anecdotes and studies the issue no further. Having studied the issue, I believe that high-frequency traders are a positive force in the markets.
High-frequency traders have lowered the cost of trading for all investors. Before the Clinton reforms, Christie and Schultz demonstrated that spreads were kept at $0.25 per share by NASDAQ market makers. Scott Patterson has found that today "fast traders make money by picking up pennies and nickels" on the spread. What happened to that twenty-four cent difference is an important consideration for those seeking to regulate high-frequency traders. If investors are keeping even some of that twenty-four cents, then the system is generally working as intended.
Studies indicate that the lion's share of the 24 cents per share is staying in the pocket of investors and that high-frequency trader profits are derived almost exclusively from 1 penny spreads. Circumstantial evidence agrees with the empirical studies on the positive effects of high-frequency traders. For example, The Vanguard Group told the SEC that, "regulatory changes and efficiencies produced by high-frequency firms reduced costs for long-term investors by about 0.5 percentage point over the last decade." When you multiply the effect over the roughly $3 Trillion that Vanguard alone manages, the savings are $15 Billion. Mark Gorton of Tower Research estimates that, "Both large and small investors are saving billions of dollars every year due to the new electronic market structure and high-frequency trading."
This cost reduction for retail investors was exactly what was anticipated when the Clinton reforms were enacted. It was as clear 20 years ago as it is now -- high-frequency traders competing against one another for penny spreads serve the interests of institutional traders and their retail clients. The popular concern that ordinary investors are losing a couple of billion dollars a year to high-frequency traders is laughably short-sighted. Mrs. Clinton's policies are equally so.
Currently, despite Mrs. Clinton's contrary assertions, investors enjoy low costs and "the most level playing field ever" in the securities market. This is, in part, due to the competition President Bill Clinton fostered between high-frequency traders. Rather that attack that accomplishment, Mrs. Clinton should focus her considerable talents on those high-frequency traders who try to take more than they are entitled to under the Clinton era bargain.