The publication this week of Michael Lewis’ new book Flash Boys has led to a heated debate about the role of high-frequency trading in today’s global financial markets. The most contentious spark was Lewis’ claim on 60 Minutes that the prevalence of such trading means that our markets are “rigged,” an accusation that touched a nerve and set off a furious series of discussions in the past few days.
The release of the book also coincided with news that the FBI has been investigating hedge funds that utilize high-frequency trading for possible violations of the law, including market manipulation. The FBI is not alone in its investigations. For at least two years, the Securities and Exchange Commission and the Commodity Futures Trading Commission have also been looking into the practices of these funds along with the preferential relationships that they have established with exchanges. For instance, many funds pay the exchanges substantial sums for “direct access” to the data feeds of the exchange and the pricing of stocks, which no individual investor could obtain.
The debate about whether these practices are benign or harmful to markets is entirely necessary. Personally, I think that the advantages enjoyed by some high-frequency traders are incompatible with fair and open markets and should be curtailed substantially—perhaps entirely.
But there is another danger here that is getting only minimal attention: that regulators, who once again are accused of being slow to respond and insufficiently vigilant, will go to the other extreme and attempt retroactively to criminalize behavior that it was fully aware of and did nothing to prevent until public opinion shifted.
As longtime market watcher Barry Ritholtz points out, none of the flurry of revelations has cast light on any dark secrets. The cozy and financially satisfying relationship between funds dedicated to high-frequency transaction and electronic exchanges that can execute trades in milliseconds has been going on for at least the past five years.
Lewis documents one company called Spread Networks that reportedly spent $300 million to lay an 825-mile cable between its servers in New Jersey and the Chicago Mercantile Exchange in order to obtain data feeds more quickly. There are also numerous examples of certain funds being allowed to locate their servers in the same space as the Nasdaq exchange, among others.
Yet as surprising as these revelations are to many, market participants have been aware of them from the get-go. None of what is currently being discussed was a secret to anyone on Wall Street. The reactions are thus tantamount to a cry of being shocked, shocked, that there is gambling in Casablanca. And while the mainstream media can perhaps be excused for making as much of these sensational facts as possible, the same cannot be said of regulators who have had years to address these issues but have not.
Over the past decade-plus, a disturbing pattern has emerged. Financial regulators—starting with the SEC but extending to state attorneys general, the Federal Reserve, and a host of other agencies tasked with oversight—monitor activities and then are accused of complacency when problems erupt. Then, to compensate, they begin to investigate aggressively and bring charges, usually against lower-level employees who make easier targets. The prosecution of Fabrice Tourre, a junior Goldman Sachs executive who was complicit in the packaging of questionable mortgage-backed securities in the lead up to the near-collapse of the financial system in 2008–2009, is a perfect example.
The problem is the public need for scalps combined with the retroactive interpretation of law. Yes, New York Attorney General Eric Schneiderman, who has launched his own probe of high-speed trading, cautions that some of the behavior may not be strictly illegal even if it should be stopped. But that only underscores that much of what creates public outrage in the financial world is legal. The issue is not that a few rogue individuals break the law, though that of course happens; it’s that prosecutors react as barometers of public opinion. They oscillate between complacency and zealotry in a way that may satisfy public bloodlust but does little to make our financial system fairer or to level the playing field.
In the case of high-frequency trading, there have been repeated calls on various agencies to take a harder look at the privileges enjoyed by some firms and to issue regulations that prevent the egregious front-running and assorted other techniques that allow a few firms to profit in ways that no individual—or even most institutional investors—can hope to compete with. In fairness, this system evolved only in the past decade, facilitated by the evolution of computerized, information technology–driven trading. The world often changes more rapidly than our regulatory framework, and high-frequency trading is a prime example.
We should welcome the current debate and the negative spotlight cast on high-frequency trading. But that doesn’t mean that behavior that was previously deemed acceptable should be suddenly criminalized just because the pendulum shifts. The behavior can be unacceptable and be curtailed without the attendant use of state power to prosecute, fine, and potentially incarcerate. Let’s end this system of high-frequency trading that makes it possible for a few firms to profit unfairly and at times distort markets, but let’s do it in a way that avoids the bread-and-circuses spectacle of hunting for villains.
Our regulatory framework in general, whether in finance or any other aspect of life, has become too focused on punishment, often at the expense of meaningful societal reform. Since change and reform are what benefits us all, that is where our energies should go. Trials and scalps may garner media attention and act as proxies for reform, but they are a pallid alternative to the structural changes we actually need.