So I didn't like a lot of
things that Eric Schneiderman said in his "Insider Trading 2.0"speech against
high-frequency trading on Tuesday, but here is a particularly puzzling bit of
it:
Unlike the rest of us who
invest in the markets, as I hope you all do, some high-frequency traders appear
to trade with virtually no risk. This is something we’re very interested in.
Last week, a large high-frequency trading shop disclosed that it made money on
every trading day over the course of four years. Out of 1,238 trading days,
they made a profit on 1,237 of those days. I do not begrudge anyone their right
to make money, but if something seems to be too good to be true, it usually is.
And we question whether there are some traders that are just so smart that they
never, ever lose money without some special advantage.
Puzzling because, one, why does he seem to hope his entire audience of
lawyers day-trades, and, two, there's a serious misunderstanding of the
trading industry here. Schneiderman is referring to Virtu
Financial's much-discussed recent IPO filing, but similar complaints have been leveled against Goldman Sachs and JPMorgan and ... well, Goldman Sachs, a lot. Every firm that is in the trading business
seems to make money on trading on a whole lot of days, and lose money on a
whole lot fewer days.
And sure, it does seem unfair that, in the uncertain world of securities
trading, some firms would make money (almost) every day. Imagine how suspicious
it would be if, for instance, your local supermarket made money on every carton of milk that it sold. That just seems too good to be true,
doesn't it? How can they know the price of
milk before you do? Shouldn't they be losing money on half of their milk, and
making it on the other half, so that things balance out? Doesn't the fact that
they always make money suggest that they're ripping you off?
Virtu is a leading
technology-enabled market maker and liquidity provider to the global financial
markets. We stand ready, at any time, to buy or sell a broad range of
securities, and we generate revenue by buying and selling large volumes of
securities and other financial instruments and earning small amounts of money
based on the difference between what buyers are willing to pay and what sellers
are willing to accept, which we refer to as "bid/ask spreads."
That is, Virtu (like Goldman) is selling a product, and that product is
liquidity, and itcharges for
that product.1 High-frequency
trading firms are in the business of acting as middlemen, providing a valuable
service by letting buyers and sellers trade as soon as they want to, rather
than waiting for fundamental sellers/buyers to come in on the other side of the
market.
Now you could reasonably object to that business, but your objections
should have the same form as legitimate objections to other businesses. And
"that business consistently makes money!" is not a legitimate objection to most businesses. In fact it is the reverse:
Businesses that consistently make money are typically thought of as good
businesses, not bad ones.
But there are still legitimate forms of objection even to profitable
businesses. You might, for instance, think the business is too profitable, and
want to disrupt it by cutting out the middleman and letting
ultimate buyers and ultimate sellers trade directly with each other, without
passing through the hands of market-makers, high-frequency or otherwise. That's
fine! That's a rough and partial description of what dark pools are; they're
places for fundamental investors to trade without encountering middlemen. And
yet exchanges survive, because sometimes people want immediate liquidity and
are willing to pay a middleman for it. (Also: Schneiderman seems to be
anti-dark pool.2 )
Or you might worry that the business is too monopolistic, that barriers
to entry are too high. That would be an argument for providing equal access to data feeds, for instance, which is a Schneiderman priority. But you should be clear about what that means.
The goal -- and the effect -- here is not to reduce high frequency trading. It's to make high frequency trading easier, by reducing the fees that new entrants have to pay to compete with
incumbent traders. If exchanges and newswires can't charge HFT firms tens of
thousands of dollars for data feeds, HFT will get cheaper, and there will be more of it, not less.
Relatedly, you might worry that this business is profitable due to
regulatory rent-seeking rather than actual customer needs. And in fact, common
and reasonable arguments about high-frequency trading are that it takes
advantage of exchange privileges given to market-makers, or that it games
maker/taker fees, or that it otherwise takes advantage of a sophisticated
understanding of the rules to earn rents. (And, relatedly, that the desire to
earn these rents leads to an escalating arms race: The rents accrue not based
on absolute speed, but disproportionately to whoever is fastest.)
You will hear critiques like this from high-frequency traders themselves,
about their competitors: "We don't game maker/taker rules, but those guys do." These are mostly arguments for less
regulation, rather than more, though to some extent they fit with
Schneiderman's desire to crack down on the special privileges that exchanges
offer to HFT firms.
Or you might just say, "the people currently doing the business do
a bad job of it, I wish someone did a better job."3 That is a
fine thing to say if you are planning to start a trading firm! As a regulator,
though, it's somewhat less impressive; a regulator has lots of power to
restrict bad businesses but little power to will good businesses into
existence. You (probably) can't make trading costs come down by increasing the
costs of the guys currently doing the trading.
So, I don't know, there are plenty of sensible positions you can take
against high-frequency trading, and Schneiderman even arguably takes some of
them. But "high-frequency traders consistently make money trading, and
that is too good to be true," is not such a sensible position. If you find
yourself unable to understand how the people you regulate make money, that does
not in itself mean that you need more regulation. It means you need more
understanding.
