Is the Stock Market Rigged, or Has Michael Lewis Jumped the Shark?

Posted by Alex Frey (@alexhfrey )
Michael Lewis' image of how the stock market works

"The pen is mightier than the sword." My grade-school self used to laugh that saying off as composition-teacher propaganda of the sort designed to get energetic boys to pay more attention to their writing exercises and less attention to playing violent video games. I'm now coming around to the opinion that my English teachers may have been on to something profound.

If you were going to produce a list of the most powerful pens in the world, you would have to include Michael Lewis' somewhere on that list. The acclaimed author of hits like Liar's Poker, Moneyball, The Blind Side, and The Big Short (among others) can spin a narrative that is so good that it makes even those who couldn't tell a stock from a bond want to pay $20 to read about arcane financial topics like mortgage-backed bonds and high frequency trading.

The latter is the topic of Flash Boys, Lewis' latest book that was out last week. It purports to explain how there is "a high-tech predator stalking the equity markets." In an impressive display of buzzwords, the book's description says that it will show that "the U.S. stock market has been rigged for the benefit of insiders and that, post–financial crisis, the markets have become not more free but less, and more controlled by the big Wall Street banks."

It's easy to see why Lewis has shot to the top of the bestseller list and been featured prominently on 60 Minutes: by weaving big Wall Street banks, high-tech predators, shady insiders, rigged markets, and robot computer algorithms into a flowing narrative, he plays to a handful of our deepest-ingrained fears and beliefs -- and tells an entertaining and fast-paced story to boot!

But after perusing the Kindle version of Flash Boys, there's another adage from my elementary school days that I can't help recalling: with great power, comes great responsibility. In this case this roughly translates as: if you can tell us a spellbound narrative, we will give you some "artist's liberty" so long as we trust that you are faithfully getting the direction of the story -- the "truth behind the truth" -- correct.

On that front, many informed market observers are now charging that Lewis has failed to live up to his end of the bargain -- that he has abused his power to tell a spellbinding narrative by feeding us a story about the markets being "rigged", that many of us are predisposed to want to believe, but that is not actually supported by a dispassionate analysis of the evidence.

I haven't totally made up my mind, but it's probably already obvious that you can count me among those that are suspicious.

The core of the skeptics argument is that Lewis never satisfactorily assesses algorithmic trading in the context of the historical services that it provides (if it is working correctly). That service is called "liquidity provision," and a little background about how markets work is in order to see what it really is and why it is important.

The Origins of Liquidity Provision as a Service

Since the days when the New York Stock Exchange was literally conducted on a street, markets have operated as a continuous "open outcry" system, meaning that they take place in real time. Anyone can offer to buy or sell shares at any time that the market is open.

But a basic problem is that we need a lot of volume in order to have a market that continuously matches buyers and sellers on fair terms. We take it for granted that we can get into the market pretty much whenever we want, but in order for this to happen someone has to be willing to stand on the other side of the trade and sell us the shares that we desire to buy. This does not happen magically.

In many cases, there are simply not enough "natural" buyers and sellers that are constantly entering the market in order to maintain a continuous and orderly market.

Imagine, for instance, that a large mutual fund wants to sell 100,000 shares of a small-cap stock. It is very unlikely that at this particular instant, there is another large mutual fund (or group of mutual funds) that wants to buy 100,000 shares of the same stock.

What has always enabled continuous orders to flow in an orderly market is the presence of intermediaries -- liquidity providers -- who are willing to fill a buy order one minute with the expectation that they will be able to quickly sell the same shares back for a profit a few seconds / minutes / hours later.

This "intermediary-class" existed long before high-frequency trading was ever a thing; in fact it existed long before computers were ever a thing.

Before the days of electronic trading, the liquidity providing function was filled by human "specialists," who would stand in a physical location on the exchange floor and "make markets" for selected securities. To be clear, by "making markets" we mean buying shares for one price in one minute and selling them back for a slightly higher price a minute later. The liquidity providers never operated as non-profit enterprises.

In large part, these specialists got their coveted position not through skill or smarts, but through connections and registrations. Stock exchanges were not open places that anyone could setup shop in -- you had to have a "seat." As a result, in these days competition was constrained, "spreads" (differences between the price that an investor could purchase a share and sell that same share) were fat and wide, and those lucky enough to be market specialists were fat and happy.

Today, trading mostly happens on a computer and is done in the blink of an eye. As a result, the barriers to entry in becoming a "liquidity provider" have drastically changed. It is not longer about having a seat at an exclusive club -- it's about having a great algorithm and a super-fast computer that is located close to the exchange. This creates a highly competitive environment where multiple market-makers compete with each other every second of the day to see who can offer the best prices.

In essence, what has happened is that the market-makers of the past have been replaced by a new group of nerdier computer-geek traders using sophisticated machine-learning algorithms.

Measuring the Size of the Liquidity Tax

The fact that a few members of this now-nerdier class of liquidity-providers now also seem to be making money should not be in and of itself be a great concern to us. If we view liquidity provision as an essential part of the creation of deep and orderly financial markets (which in turn benefit all investors), then we should view the costs of liquidity provision as a tax that anyone that trades in the markets has to pay.

A tax is the right analogy, because we need to acknowledge that both a) The implicit fees that we pay are going to support an incredibly valuable piece of infrastructure that we commonly take for granted (namely, a deep and continuous market), and b) There is always the potential for the fees to be misappropriated and used to support non value-adding activities.

The relevant questions are: 1) Has the presence of HFT increased or decreased the total amount of the liquidity tax? and 2) Can we change the structure of the market in a way that would lower the amount of tax that we all have to pay, while still providing the same services?

On the first of these, while it is hard to isolate the impact of certain HFT practices from other developments in the market, the clear evidence is that the size of the "liquidity tax" is much smaller now than it has been in the past.

One way to look at this is to measure the bid-ask spread on the average security. This measures the difference between the price that you could instantaneously purchase a share at, and the price that you could instantaneously sell it for.

The clear fact is that bid-ask spreads have decreased dramatically over time. Back in the days of the specialists, stock prices hadn't even been decimalized; amazingly, they traded in 1/8th of a dollar increments as recently as 1997. Today, the bid-ask spread is effectively less than a penny a share on many of the more liquid ETFs that we recommend in our model, making it cheaper and easier for the average person to place trades.

A slightly more complex way to calculate the size of the liquidity tax is by measuring something called an "implementation shortfall." This takes into account both the bid-ask spread, and the resulting market impact from placing an order. This is most relevant for large institutions that can "move the market" when they try to get into or out of a position (because they have to purchase so many shares that people catch on to what they are doing and adjust the price as a result).

An implementation shortfall is by its nature very difficult to measure and compare across time. But if anyone is capable of doing so, that person is probably Cliff Asness. The founder of AQR Capital Management (one of the largest hedge funds in the world), Asness is a man who my firm owes a great intellectual debt too. His papers have influenced much of the thinking behind our approach to investing. Moreover, as a large trader (but not a high frequency trader), Asness has a very large incentive to make sure that he is paying the lowest trading costs that he can. So he would also be a great candidate to lead the charge against any unfair practices that were driving costs higher.

We should pay attention to Asness then, when he says that "we devote a lot of effort to understanding our trading costs, and our opinion, derived through quantitative and qualitative analysis, is that on the whole high-frequency traders have lowered costs."

Of course, saying that things are better for the average investor then they have been in the past does not necessarily mean that markets are still not "rigged" (though it would seem to suggest that they are at least less "rigged" then they were before, or at least that the costs of the "rigging" are much smaller than they were before).

Shouldn't we be unsatisfied with a market structure that, according to Lewis, enables HFTers to "front-run" customer orders? We absolutely should, but a couple caveats are in order.

First, a clear distinction needs to be drawn between actual front-running (trading in advance of someone with direct knowledge of an order they are about to enter), and between "anticipatory" front-running (building an algorithm that predicts someone's order before it enters the market). It's not totally obvious to me which of these is occurring with HFT.

Second, what seems more or less irrefutable is that it is hard to find much evidence in the data that the pain caused by some of these supposedly unsavory practices is worth quite the attention that we are now, as a result of Flash Boys, giving to them. For instance, an academic paper from professors at the University of California, Berkeley estimated that if some kind of "front-running" is occurring, the median cost to the average investor in Apple would be about a penny a share. That is less than .01% of the share price. And they only found evidence that this kind of price dislocation occurred about 1% of the time. That's certainly worth examining and fixing as it can add up to a relatively large amount in aggregate, but it seems hyperbolic to call the stock market a "rigged game" based on occasional .01% dislocations in trading prices.

Why This Matters: The Making of an Investing "Narrative"

This matters precisely because stories are so powerful and important. The narrative that we tell people when they are thinking of investing some of their hard-earned money in the stock market can impact all kinds of things, from savings rates, to faith and confidence in the market, to investor returns. And there are starkly different narratives out there. The narrative that Lewis is pushing says that the stock market is rigged, and that as a small investor you cannot hope to win. But there's another narrative that says that "there has never in the history of the world been a better time to be an individual investor."

Now both those narratives might have some truth to them. But based on an analysis of the data, the latter narrative seems much more difficult to refute than the former. In terms of market access, liquidity, trading costs, and product choices, there really has never been a better time to be a small-time do-it-yourself investor. But I doubt telling that story would get you to the top of the best-sellers list.

On that note, it's worth considering whether any of this should really matter to Michael Lewis, who has managed to jump to the top of the bestseller list and create a national debate about a previously arcane topic?

It may not, but a cautionary tale comes from an old "Happy Days" episode that aired long before even "Liars Poker". In a now-infamous episode in the series' fifth season, the character Fonzie jumped over a shark while on a water-ski. That particular scene might have gotten a lot of attention at the time, but it also came to be remembered as the start of a descent in quality of a once-great series. Since then, the phrase "jumping the shark" has been used to refer to the point in a television series when a deterioration in quality is evidenced by the writers reliance on a "gimmick designed to keep viewers' interest."

With Flash Boys, Michael Lewis is getting perilously close to jumping the shark.

DISCLAIMER: I am by no means an expert on high frequency trading and am not in any way defending or excusing any "front-running" or other illegal or unethical practices that may be occurring.


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By Alex Frey