The idea that retail investors are losing out to sophisticated speed traders is an old claim in the debate over HFT, and it’s pretty much been discredited. Speed traders aren’t competing against the ETrade guy, they’re competing with each other to fill the ETrade guy’s order. While Lewis does an admirable job in the book of burrowing into the ridiculously complicated system of how orders get routed, he misses badly by making this assumption.

The majority of retail orders never see the light of a public exchange. Instead, they’re mostly filled internally by large wholesalers; among the biggest are UBS (UBS ), Citadel, KCG (KCG ) (formerly Knight Capital Group), and Citigroup (C ). These firms’ algorithms compete with each other to capture those orders and match them internally. That way, they don’t have to pay fees for sending them to one of the public exchanges, which in turn saves money for the retail investor.

according to estimates from Rosenblatt Securities, the entire speed-trading industry made about $1 billion, down from its peak of around $5 billion in 2009. That’s nothing to sneeze at, but it isn’t impressive once you put it into context: JPMorgan Chase (JPM ) made more than $5 billion in profit  in just the last quarter.

If that doesnt convince you, just listen to all those Keynesians who are proudly calling this a form of useful economic stimulus, akin to pyramid-building, or an invasion from outer spaceoh wait

118 comments

The counterargument of retail investors not being affected because their retail orders are not affected is ridiculous. Is it true that on their retail orders they are not directly impacted? Yes. Does that mean that retail investors are not affected? No.

John Thacker April 2, 2014 at 11:11 am

Sure. But isnt the way that theyre affected mostly that the bid-ask spread has declined as a result of HFT? And doesnt that help retail investors (and hurt the brokers)? Please correct me if Im wrong.

JB April 2, 2014 at 11:28 am

Sure. But this decline that is attributed to HFT is about electronic exchanges and automation and really got nothing to do with the types of strategies that should not be allowed. Everything is cast under the HFT umbrella these days if it is automated, but most automated trading has got nothing to do with predatory strategies like quote stuffing, yet everything seems to be labeled as the same.

I am not anti-HFT. There were a lot more intermediaries taking a much bigger piece of the pie before, but automation and electronic exchanges have improved conditions for every investor out there. That does not mean one should not try and avoid some of the predatory strategies out there.

John Thacker April 2, 2014 at 11:45 am

Well, isnt that a terminology question? Automation and electronic exchanges enable higher frequency trading, which enables potentially dubious strategies. I think that people do talk past each other a lot, like youre saying. Its not unreasonable to put everything to do with electronic exchanges and automation under the HFT rubric, though I can understand wanting to exclude it.

JB April 2, 2014 at 1:00 pm

But no one is criticizing automation and electronic exchanges. Dubious HFT strategies might depend on these two factors, but automated trading and electronic exchanges does not depend on these strategies.

E.g. information should not be made available earlier to anyone. Today this is not always the case for trading and economic information. In essence this is facilitation of front running.

On the other hand I have no sympathy for the old school guys whining about their block trades moving prices because they have not adapted to the necessary use of algorithms to execute their trades (also, who told them that sales of big blocks of assets werent supposed to move prices?). If someone wants to exploit these guys without quote stuffing or early information access, be my guest.

HFT Trader April 2, 2014 at 2:17 pm

E.g. information should not be made available earlier to anyone. Today this is not always the case for trading and economic information. In essence this is facilitation of front running.

Im curious how you think this is happening. If youre talking about a direct exchange feed, anyone can sign up for one. The reason that I dont have a direct NASDAQ feed running to my house to trade my 401k is because it wouldnt matter for me. Even if all participants got all the information from the same feed at the same time, a computer can make a decision in 50 microseconds and a human cannot. In your hypothetical HFT-free but still electronic world would you also require a computer to wait a few seconds before making a decision? Computers can also analyze terabytes of data to discover tiny statistical edges, would you also outlaw this to since its a form of information not available to the common man?

I just dont understand how you think its possible to have a financial system where everyones on equal informational ground. Do you also object to the fact that brokerage customers get access to sell-side research? How about that Wall Street Journal subscribers get articles that non-subscribers cant read?

Rahul April 2, 2014 at 4:14 pm

@HFT Trader

Wasnt flash trading (perhaps obsolete / banned now) one such avenue to make information available earlier to some?

Quoting Wikipedia:

Flash trading is a form of trading in which certain market participants are allowed to see incoming orders to buy or sell securities very slightly earlier than the general market participants, typically 30 milliseconds, in exchange for a fee

HFT Trader April 2, 2014 at 4:47 pm

Flash trading was discontinued years ago about all the major exchanges. So this may be a moot discussion, but heres my take on it. First off the way flash trades worked is that youd send an order and designate flash-able. (Note that all the supposed victims whose orders were flashed and front-runned were voluntarily using the system.) If your order didnt match any liquidity resting on the book NASDAQ would display an Indication of Interest (IOI) on its flash feed for a short interval, usually 30 ms or so. After that whatever was unmatched in the flash would be treated it like a regular order, either resting it on the book, routing it or canceling it depending on the order specifications. (To add, anyone listening to flash IOIs were legally obligated not to use them to inform their regular market trading. Youll have to take this on my word, but my colleagues at the time, at one of the top tier HFT firms, who worked on equities took this very serious.)

If this sounds like a dark pool, its because its basically what it is. Its essentially the same thing Credit Suisse does when you send an order to their dark pool. First they try to match it on any resting liquidity, then if you indicate you want it the order will notify other dark pool participants and rest for a certain period of time, if it expires it will route to the lit exchanges. Same as the flash feed, Credit Suisses dark pool IOIs are only displayed to subscribers and never go on the consolidated public feed. Now theres an argument to be made that all trading should take in the lit, public market. This is how futures work by their nature. But stocks traditionally have never worked this way, at the very least you always have the right to call up your friends and privately negotiate a sale of your stock. Dark pools are just an extension of this, and flash trading were just a type of dark pool that were run by the exchanges itself. So it seems to me that if youre going to make the argument that flash trading is bad because its not done on public markets, it also has to apply to block trades that happen over the phone.