As a co-author of the original article, I want to thank all the commenters for their interest and willingness to take time to debate this issue. Many of you have raised points which get right to the heart of the issue. In my own career, I have been a sell-side (brokerage) trader in both derivatives and equities, head trader of the what is now the world’s largest asset manager, co-creator of the POSIT alternative trading system, portfolio manager, and retail investor. As I read the comments, I observed a few themes that I’d like to address: the fairness of unequal information in free markets, trading profits , and the nature of front-running. I’d like to address these issues.

First, the fairness of unequal information in free markets.

Warren Buffett made great deals recently with Goldman, Dow and others. These deals were not offered to the public at large. The sellers made a decision to selectively disclose their trading intentions, and Buffett benefited due to his reputation, ability to make a quick decision, and hoard of cash.

In 2007 there were 75 million American homes occupied by owner, with a median value of $191,000, for a total value of around $15 trillion. Today’s stock market capitalization is around $11 trillion in the US, so it’s safe to say that housing is a bigger asset class than stocks for the average American. If you are buying a condo in a building, you may have no idea of the last sale for the same model you want for a couple of months from the time the deal was struck. There are huge commissions and fees compared to stock trading. The seller may be seeing multiple bids on a property, while a buyer might only be aware of his own bid. The high transaction costs make it difficult for intermediaries to make a market in homes. If you need cash, you can sell stock in 10 seconds and have the money in 3 days. If you own a house it may take you 10 months or more.

Wal-Mart knows how to source in China and other places, and has created an extremely efficient distribution system. Its low pricing has put a lot of competitors out of business—competitors who don’t have that knowledge of overseas sourcing or can’t match the distribution costs.

Free markets don’t require equality of information. They require an absence of coercion, and protection against fraud. Free markets allow people and firms to develop expertise which create competitive advantages. Users of free markets who don’t care to develop expertise can still benefit from them. Wal-Mart customers, with no sourcing skills of their own, benefit from Wal-Mart’s efficiencies in the form of lower prices.

Twenty years ago, retail stock traders had to call in orders and wait 20 minutes or more for reports. They might miss markets due to the lag between their broker getting an order and the order getting to the post. They could not have their bid or offer shown on NASDAQ. Spreads were a minimum of an eighth of a point, and often more. Today they can go to the web, enter an order and get an execution in seconds. The spread on large cap stocks is as little as a penny. They did not have to develop any expertise to obtain these benefits. They arose, “trickled down” if you will, out of the forces of competition created by free markets. TD Ameritrade uses flash trading to improve executions for its retail clients. The clients may have never heard of flash trading, but they are reaping the benefits of selective disclosure. I’m sure TD Ameritrade will stop the practice if its data show the practice is hurting their clients. By the way, stock trading commission rates are down about 90% or more in the past 4 decades.

Some commenters felt that exchanges must treat everyone equally. In my experience, this has never been true. Customer orders often received favored treatment relative to firm or specialist orders. Program traders have been subject to different rules than other traders as so-called “circuit breakers” restricted their trading when the market made large price movements. Automated Trading Systems arose to create market segments that appealed to customers with certain types of order handling requirements. These were free markets, subject to the rules of the ATS, which itself was subject to overriding governmental anti-fraud rules.

We need these electronic markets because there is simply too much volume for humans, unassisted by machines to handle. Yet traders have found the need to replicate core trading functions, such as selective disclosure, in the electronic environment.

What about Profits?

Senator Schumer stated the possibility of $21 billion in profits being made by high-frequency traders. The implication is that profits are bad. Wal-Mart will make $15 billion this year. Yet consumers shop there because they save money. Seems like Wal-Mart’s been reinvesting profits to increase its competitive advantages. Without profits, they could not invest for improvement in their operations. High-frequency traders made money because they improved the American system of trading as it transitioned from a virtual monopoly to a competitive environment that produced the benefits described above. Have we forgotten the profits the specialists used to make? I suppose the buggy whip makers objected to the obscene profits of the automakers. Once again, a segment of the American economy is transformed by a new industry that makes greater profits than the one it replaced, while providing even bigger benefits to consumers.

Finally, let’s address front-running. When Goldman approached Buffett, they probably felt certain that he wouldn’t use the information against them. It is not front-running to respond to a flash order with a trade. The flasher is being helped, and the responding trader has every right to use the publicly available information of current bid/asked and size to inform his trade. But let’s get real here. After all, doesn’t every single-stock trade involve some sort of front-running, in the sense that the buyer thinks he knows something that makes him want to buy now because the stock is going up, and the seller has the opposite view? In his recent book on the collapse of Lehman, author Larry McDonald talks about the time he and a colleague went to the bar across the street from New Century Financial’s headquarters, met some of the salespeople, and went back to New York and opened a huge short position. They had information most people didn’t have, and acted upon it. Someone getting flashed a 1,000 share order, just a fraction of a stock’s daily value, has no idea whether the other side of the trade has knowledge like McDonald had or not, or whether it’s the opening salvo of a one million share institutional order. Front-running is just not an issue in the typical flash trading scenario, as there’s just not enough certainty as to the future direction of the stock price as to meet the high standard for front-running.

Posted by Donald L. Luskin at 10:43 AM | link  

Wednesday, August 26, 2009