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High-speed trading debunked

High-frequency trading (HFT) drew national attention earlier this year from author Michael Lewis’ latest book, Flash Boys. But Finance Professor Terrence Hendershott has been studying its effects since 2005, when investor-specific data on algorithmic trading transactions started to become available. Here Hendershott weighs in on whether high-frequency trading is good, bad, or simply inevitable.

How is “high-frequency trading” different?

Financial markets and stock exchanges aren’t real places anymore with a bunch of people standing around yelling out prices. Instead, you have a bunch of computers next to each other. Traders need their computers located as close to the exchange servers as possible because that’s how you can trade the fastest.

In Flash Boys Lewis claims high-speed traders are gaming the market by using complex algorithms. Do you agree?

Lewis writes a compelling story, but large institutions have always complained that they can never trade as much as they want without prices moving. Lewis talks about well-known short seller David Einhorn, whose hedge fund has made a lot of money. Whenever Einhorn is selling, you don’t want to be the person who’s buying. High-frequency traders figured out how to use technology to avoid being run over by big investors like Einhorn, who are unhappy because high-speed trading means they aren’t making as much money as before.

The book portrays it as some enormous conspiracy, and that part is untrue. There were people who could no longer trade the way they used to, and they stopped doing as well. We can’t slow down the economy to help the buggy whip manufacturer stay in business.

What does high-speed trading mean for the small investor?

Most small investors use online brokers such as Schwab and Ameritrade, which send their customers’ orders directly to high-frequency trading firms such as Citadel and Getco. They never go to the public market or undergo any sort of distortions that Lewis was writing about. And these small investors are arguably better off because the spread between the price you can buy or sell at, or bid and ask price, has become narrower over time. So they pay less to trade in terms of the cost of the spread.

Small investors also invest lots of money through large institutions—mutual funds, retirement funds. This is where there are more interesting questions. The concern is that high-frequency trading would somehow generate a small tax on your retirement fund because every time your retirement fund trades it pays a little bit more, so your rate of return is lower.

Your latest research found that high-frequency trading makes prices more efficient. That’s good, right?

We got some data from Nasdaq that identifies high-frequency traders, and we looked at whether their trading helps predict future price changes. The answer is yes. Next we want to look at how it does this.

What is the future of high-speed trading?

Unless the regulators change the rules, high-frequency trading is here to stay because it is simply a more efficient way of certain types of trading. It is a cutthroat business where firms continually invest resources in being as fast and smart as possible. I don’t see that changing. –Interview by Pamela Tom

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