At the outset I should admit that I am a fan of Lewis’ past work as he combines a rarely published combination of insider’s knowledge of financial markets and engaging story telling. However in Flash Boys I believe Lewis muddies two important principles that should govern financial markets: First that markets should be fair to all participants and second that individual participants should be rewarded for their hard work. My criticism is best explained through a series of thought experiments.
Experiment 1. Imagine Tom and Doug are each professional investors. They each receive a copy of the latest GE Annual Report at 5pm one afternoon. Tom is a diligent professional and stays up all night reading the full report including all footnotes to the financial statements. Doug is bright but lazy and goes out drinking all night. At market open each places a trade in GE. Tom makes a fortune based on his analysis of a subtle trend revealed in the segment detail relating to GE Credit; Doug loses his shirt.
Is this an unfair result? Should the securities laws prohibit Tom from working this hard so as to level the playing field with the lazy Doug? Few if any of us would say yes. However if this is the case we have implicitly accepted the principle that markets can reward participants unequally based on their work efforts.
Experiment 2. Same facts as above; however this time the diligent and wealthier Tom decides to hire a promising accounting student to stay up all night and pore over the GE financial statements. When Tom and Doug trade the next day Tom makes the same profits (less what he paid the student) while Doug gets wiped out.
Again few of us perhaps outside France would say that our sense of market fairness precludes Tom from paying for and profiting from research performed on his behalf. Now we have accepted the principle that markets can reward participants unequally based on their ability to fund research.
Experiment 3. In this example Tom and Doug have each performed the same research but Tom has purchased an expensive fiber connection to the stock exchange while Doug relies on an old AOL dial-up connection. Again Tom makes a killing while Doug loses his shirt.
Perhaps this is a slightly more difficult case; however if you accept the result of Experiment 2 I see no reason why I should not be able to use my money to purchase a speed advantage as opposed to an information advantage.
In each of the foregoing examples an unequal starting position in work or capital has turned into a trading advantage but unless one wishes to argue that the securities laws should be designed to counteract all differences in society I cannot see a principled basis to deny Tom from profiting from his hard work or investment. This is not to say that I do not endorse efforts to achieve a more just and equitable society at large (see e.g. Pinketty Capitalism in the 21st Century); however I do not believe we should conflate the very relevant discussion on economic inequality with what constitutes unfair trading practices.
I do not here want to get into the debate as to the benefits if any of High Frequency Trading. There is a respectable argument made as to the enhanced liquidity and price transparency HFT brings to the equities market just as a similar claim is made in favor of another hated practice short selling. I want to focus here instead on which practices truly harm the proper functioning of our markets and which simply seem unfair based on the fuzzy logic I challenge in Experiments 1-3 above.
I believe there are trading practices that harm markets and should be prohibited – front running by an agent against its principal and insider trading by the officers of an issuer are but two examples. These are wrong not because of differences between the work undertaken or money spent by the trader but because in each case a fiduciary duty is owed by the agent or officer to the principal. Similarly the US securities laws have long prohibited fraud and misrepresentation.
My mission is not to defend or protect high frequency trading. Rather it is to disentangle the arguments raised against these practices so as to focus on protecting the quality and fairness of free markets not to attempt to level all differences among market participants in the interests of some idealized concept of equality. Thus I would be perfectly comfortable with a rule that prohibited HFT firms (or anyone else) from submitting thousands of orders that are then rapidly cancelled if the sole reason for placing the orders were to discover the prevailing market price or spread (NBBO) and then trade on that knowledge. However my rationale would not be that it is unfair to allow the HFT firm to use its incredible investment in speed it would be that as a policy matter we want bids and offers submitted into execution venues to represent either actual investment decisions or activities such as market-making undertaken by broker-dealers in the ordinary course of business.
Some may think this is a distinction without a difference. However I believe it is important to maintain free and fair securities markets and this in turn requires clarity of regulatory thought.
