Unless you’ve been in a bunker like the “Unbreakable Kimmy Schmidt”, you’re aware of how polarized our society has become. Rising to a fever pitch since the last election, people are labelled–and often pilloried–based on what candidate they “support”. We have learned that one of our strongest tendencies when surfing the Web is to read sites biased in the same direction we believe. On each issue, therefore, each side often calls reports which disagree with them “fake news” and many people seem to be losing the capacity for critical thinking. The result is often extreme oversimplification and pejorative labeling, rather than reasoned argument. This ends up meaning that, if a concept needs more than a sentence of explanation, it becomes almost irrelevant. It does not matter if it is a political debate, an election, or the discussion of a complex public policy issue; The public discourse today ultimately boils down to soundbites and labels.
So, what does this have to do with equity market structure?
The answer, is that the polarization of market structure debates, particularly regarding HFT, speedbumps, and technology in general has reached a ridiculous level. There is a group of media-savvy people who classify others as HFT “apologists” or “supporters.” ridiculing or ignoring their arguments without considering their merits. There are also a group of people (that I am usually grouped with) who believe technology has made the equity markets more efficient and who argue for more transparency rather than prescriptive rules, which are often designed to protect the business interests of the firms proposing them. The reality, however, is that these issues are nuanced and do not often lend themselves to soundbites and one sentence explanations.
This saddens me, since institutional investors should be laser-focused on improving their investment performance and many brokerage firms are under intense competitive and regulatory pressure. Neither of them have the luxury of ignoring information or not doing business with firms that can help them, but it happens quite often.
When history evaluates this time-period, it will likely be remembered for the furor of well-paid traders and sales people faced with reduced compensation and even layoffs, mainly caused by the advance of technology. That furor reached a fever pitch when Michael Lewis wrote “Flash Boys” and then appeared on 60 Minutes claiming the “markets are rigged” a few years ago. While the massive media coverage that followed has since died down, the polarization has yet to abate. Firms still leverage people’s irrational fear of machines in financial markets to either drum up business for themselves or to disparage the views and data produced by their competitors.
In the case of HFT firms in general, I will admit to thinking that the voluminous academic data proving that they have reduced transaction costs and make less money than the companies that they out-competed, proves their value. They are not perfect, however, and neither are the surviving brokers who have adopted more technological approaches. Their issues have been well documented, which is why I have been an unflinching campaigner for enhanced best execution disclosures and better TCA (Transaction Cost Analysis).
I also admit that my intuition is that trading firms who have not invested in quantitative technology probably do not deliver best execution. There are exceptions to this, but brokers who specialize in sourcing liquidity in difficult situations tend to be quite forthright about their business model. I will also admit to being extremely critical of firms and people that oversimplify the issues and conflate the results from different services they provide. This explains why I have repeatedly called for order routing and market center execution quality disclosures to separately categorize the statistics by each different order type.
But I digress. The polarization in market structure debates has led to people questioning if I am being paid by specific HFT firms, presumably to disparage my point of view. This is wrong on many levels, including client confidentiality, but I decided to answer these questions with a simple “NO.”
That said, while I am not currently being paid by any firms labeled as HFT or by firms who represent them, I would be proud to do so. I would not have a problem working for any trading firm or exchange by auditing and providing direction on the development of proper metrics. To those who question my objectivity I say, I will let the data do the talking.
The reason why I would be proud to work with HFT firms, is simple. I believe that innovative, (and disruptive) firms such as Citadel, Virtu, HRT, GTS, Tradebot and my former employer Two Sigma have helped improve markets by tightening spreads and providing both liquidity and price improvement to customers. The supposedly extreme profits earned by these firms pale in comparison to the economic rent earned by their predecessors. Those intermediaries, market makers and specialist firms from 15+ years ago earned much more than today’s HFT firms in the aggregate, and even more on a per share basis. The market capitalization of intermediaries in 2000 was much, much higher than today, which is reflective of the reduced profits being made, no matter what the market structure pundits claim. The best example may be that the combined market capitalization of Virtu and KCG (the successor to Knight Securities) is around half of what Knight alone was worth at that time. Compared to the 2000 version, the combined firm’s equity trading revenues are a relatively much smaller contributor to the bottom line, even though it has a larger market share. In addition, the value of equity market making and specialist franchises across Wall Street was much higher than today, as evidenced by thousands of fewer traders and salespeople earning 6 and 7 figure incomes.
Does this mean today’s market is perfect? Of course not.
Does it mean HFT firms are perfect? No. But, their small profit margins, especially compared to the firms that preceded them, have contributed to lower overall costs to investors.
The important question, however is: Would I ever post commentary that I did not believe in fully because I was paid to do so? The answer is NO! Most of my commentaries are about facts backed up with empirical data, and I prefer to concentrate on data analysis in the context of different types of trading. To that end, I will continue to post on analytical topics such as evaluating displayed markets in a different context than dark liquidity, how to construct better benchmarks for liquidity demanding trades and how to analyze opportunity costs appropriately. I will also sprinkle in commentaries about the asset management process to keep from becoming one-dimensional. Stay tuned!