Superfluous Financial Intermediation

I'm only about halfway through Flash Boys but have already come across a couple of striking examples of what might charitably be called superfluous financial intermediation.

This is the practice of inserting oneself between a buyer and a seller of an asset, when both parties have already communicated to the market a willingness to trade at a mutually acceptable price. If the intermediary were simply absent from the marketplace, a trade would occur between the parties virtually instantaneously at a single price that is acceptable to both. Instead, both parties trade against the intermediary, at different prices. The intermediary captures the spread at the expense of the parties who wish to transact, adds nothing to liquidity in the market for the asset, and doubles the notional volume of trade.

The first example may be summarized as follows. A hundred thousand shares in a company have been offered for sale at a specified price across multiple exchanges. A single buyer wishes to purchase the whole lot and is willing to pay the asked price. He places a single buy order to this effect. The order first reaches BATS, where it is partially filled for ten thousand shares; it is then routed to the other exchanges for completion. An intermediary, having seen the original buy order on arrival at BATS, places orders to buy the remaining ninety thousand shares on the other exchanges. This latter order travels faster and trades first, so the original buyer receives only partial fulfillment. The intermediary immediately posts offers to sell ninety thousand shares at a slightly higher price, which the original buyer is likely to accept. All this in a matter of milliseconds.

The intermediary here is serving no useful economic function. Volume is significantly higher than it otherwise would have been, but there has been no increase in market liquidity. Had there been no intermediary present, the buyer and sellers would have transacted without any discernible delay, at a price that would have been better for the buyer and no worse for the sellers. Furthermore, an order is allowed to trade ahead of one that made its first contact with the market at an earlier point in time.

The second example involves interactions between a dark pool and the public markets. Suppose that the highest bid price for a stock in the public exchanges is $100.00, and the lowest ask is $100.10. An individual submits a bid for a thousand shares at $100.05 to a dark pool, where it remains invisible and awaits a matching order. Shortly thereafter, a sell order for a thousand shares at $100.01 is placed at a public exchange. These orders are compatible and should trade against each other at a single price. Instead, both trade against an intermediary, which buys at the lower price, sells at the higher price, and captures the spread.

As in the first example, the intermediary is not providing any benefit to either transacting party, and is not adding liquidity to the market for the asset. Volume is doubled but no economic purpose is served. Transactions that were about to occur anyway are preempted by a fraction of a second, and a net transfer of resources from investors to intermediaries is the only lasting consequence.

Michael Lewis has focused on practices such as these because their social wastefulness and fundamental unfairness is so transparent. But it's important to recognize that most of the strategies implemented by high frequency trading firms may not be quite so easy to classify or condemn. For instance, how is one to evaluate trading based on short term price forecasts based on genuinely public information? I have tried to argue in earlier posts that the proliferation of such information extracting strategies can give rise to greater price volatility. Furthermore, an arms race among intermediaries willing to sink significant resources into securing the slightest of speed advantages must ultimately be paid for by investors. This is an immediate consequence of what I like to call Bogle's Law:

It is the iron law of the markets, the undefiable rules of arithmetic: Gross return in the market, less the costs of financial intermediation, equals the net return actually delivered to market participants.

I hope that the minor factual errors in Flash Boys won't detract from the book's main message, or derail the important and overdue debate that it has predictably stirred. By focusing on the most egregious practices Lewis has already picked the low-hanging fruit. What remains to be figured out is how typical such practices really are. Taking full account of the range of strategies used by high frequency traders, to what extent are our asset markets characterized by superfluous financial intermediation?

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Update (4/11). It took me a while to get through it but I’ve now finished the book. It’s well worth reading. Although the public discussion of Flash Boys has been largely focused on high frequency trading, the two most damning claims in the book concern broker-dealers and the SEC.

Lewis provides evidence to suggest that some broker-dealers direct trades to their own dark pools at the expense of their customers. Brokers with less than a ten percent market share in equities trading mysteriously manage to execute more than half of their customers’ orders in their own dark pools rather than in the wider market. This is peculiar because for any given order, the likelihood that the best matching bid or offer is found in a broker’s internal dark pool should roughly match the broker’s market share in equities trading. Instead, a small portion of the order is traded at external venues in a manner that allows the information content of the order to leak out. This results in a price response on other exchanges, allowing the internal dark pool to then provide the best match.

There’s also an account of a meeting between Brad Katsuyama, the book’s main protagonist, and the SEC’s Division of Trading and Markets that is just jaw-dropping. Katsuyama had discovered the reason why his large orders were only partially filled even though there seemed to be enough offers available across all exchanges for complete fulfillment (the first example above). In order to prevent their orders from being front-run after their first contact with the market, Katsuyama and his team developed a simple but ingenious defense. They split each order into components that matched the offers available at the various exchanges, and then submitted the components at carefully calibrated intervals (separated by microseconds) so that they would arrive at their respective exchanges simultaneously. The program written to accomplish this was subsequently called Thor. Katsuyama met with the SEC to explain how Thor worked, and was astonished to find that some of the younger staffers thought that the program, designed to protect fundamental traders from being front-run, was unfair to the high-frequency outfits whose strategies were being rendered ineffective.

This account, if accurate, reveals a truly astonishing failure within the SEC to understand the agency’s primary mandate. If this is the state of our regulatory infrastructure then there really is little hope for reform.