Has High Frequency Trading Become a Financial Race to Irrelevance?

Has high frequency trading become an end in itself, utterly divorced from the creation of real value for clients - and even for those who sponsor it?

That is a question being asked with increasing persistence - and concern. Not just by regulatory authorities who can no longer ignore the evidence, but by businesses themselves who see that their interests are no longer served by supposedly public markets.

We have dwelt in a world where finance stood off to the side of common commerce. Executives in the 1920s raised such questions and they have only grown in intensity since the financial crisis of 2007. Financiers and those who love them have brushed these challenges aside, arguing that they provide liquidity, lower costs of capital, competitiveness. They have not claimed to have supplanted motherhood, but 'doing God's work,' has been offered as an ancillary benefit - and with a straight face.

The problem is that they are having an evermore difficult time justifying their existence. The fiscal and monetary support no longer adds up, even for them. The very notion of high frequency algorithmic trading was that it condensed knowledge to its most essential elements, permitting its trading as the purest expression of capitalistic purpose. But as a Fortune 500 Chief Financial Officer recently said about the financial statements that fuel this activity, 'they are like thoroughbred race horses, beautiful to look at, but utterly useless for any practical purpose.' JL

James Allworth comments in Harvard Business Review:

(Finance) will enter a world entirely of its own — a world in which it is fighting to capture value that is completely independent of whether any is created in the first place.
John Maynard Keynes very famously proposed that the actions of rational agents in a market were akin to a fictional newspaper contest, where entrants were asked to pick who, out of a set of six women, was most beautiful. Those who successfully picked the most popular face would be eligible to win a prize. Keynes asserted that a naive strategy in such a game would be for an entrant to pick based on their own personal opinion of beauty; and that a much more sophisticated strategy would be to make a selection based on the broader public perception of what beauty is. The underlying insight behind the Keynesian beauty contest when applied to the capital markets: that people value a stock not based on what they truly think believe the value is, but rather, on an assessment of what they think everyone else thinks its value is.
It was hard not think about that analogy while reading the latest Michael Lewis book, Flash Boys. It delves into the world of high frequency trading (HFT), detailing the lengths that firms have undertaken to get a speed edge of only tiny fractions of a second. The effect of that edge? Well, to continue with Keynes’s analogy, it allowed the high frequency traders to peek at the ballots others were sending in to the newspaper before they arrived, in turn giving them the ability to cast their votes using information not yet available to the rest of the market.
Lewis’s book, and HFTs in general, have attracted a lot of attention of late. A big part of it stems from a deep and somewhat intuitive discomfort we have with how HFTs make money, and whether that’s at all correlated to the value they bring to society. Lewis does a very effective job of mounting the case that the correlation is not very high. But while that case is made, there is also an argument to be made that HFTs are not as destructive as they are made out to be in Flash Boys. Sure, stealing fractions of a cent on millions of trades isn’t doing anyone any good. But those fractions of cents would otherwise most likely be accruing to the big banks instead of these new, smaller HFT firms. As long as people have been trading stocks, there have been middlemen taking a cut; HFTs just mean that the cut is now captured by those with the fastest computers.
The broader point that has been missed in the discussion around HFTs is that they actually have very little impact on how companies are run. Because HFT firms are holding stocks for milliseconds, they’re not ever in a position where they’re voting on corporate governance issues. They have no real interest in the underlying fundamentals of the stock. As long as the stock is trading — regardless of whether it’s going up or down — HFTs can take their cut. Because of this dynamic, executives have no reason to pay any attention to them when making decisions.
In terms of the real world of building businesses and creating value, basically, HFTs don’t matter.
But that, in turn, is exactly what makes them so interesting. They represent the logical extension of a topic that’s captured the attention of a lot of great business minds for some time: the ongoing battle between those who view companies through the lens of building something, and those that view it through the lens of finance. HBR is running a special section at the moment dealing with just this; asking whether investors are bad for business. Clayton Christensen and Derek van Bever dig in on this topic, and they identify a number of reasons companies are being pressured to act with an increasing short-term focus.
This pressure poses a problem for people who are trying to build something. It’s hard to create something truly valuable — it takes a lot of time. A lot of patience. Many mistakes are made along the way. There’s a fantastic interview with Jeff Bezos where he talks about it: “I think some of the things that we have undertaken I think could not be done in two to three years. And so, basically if we needed to see meaningful financial results in two to three years, some of the most meaningful things we’ve done we would never have even started.”
Now, there are some rockstar CEOs — who oftentimes happen to be founders, such as Bezos, Steve Jobs, Reid Hastings — who have the ability to resist the pressure that the markets put on them.  But what about everyone else? Well, it’s becoming increasingly hard to resist that pressure. The financial markets put pressure on you to generate the type of returns they’re looking for: quarterly results. If you’re an executive and your job lives and dies on those results, then you begin to realize that that’s what you need to deliver. Projects that take longer than that to materialize — particularly those that result in an upfront dip in earnings due to investment — get deprioritized.
In effect, financial markets are pushing companies to run a marathon… by having them sprint every lap.
It makes no sense to let such finance-oriented, short-term pressures seep into the economy’s innovation engines. The arguments against doing so continue to mount. And yet, as I was reading Lewis’s book on high frequency trading, I couldn’t escape the feeling that finance itself was making the most convincing argument of all: that given its way, it would reduce itself to computer algorithms, racing to see who can buy and sell stocks the fastest, in the ultimate of zero sum games.
High frequency trading is a different phenomenon from the increasing focus on short term returns by human investors. But they’re borne from a similar mindset: one in which financial returns are the priority, independent of whether they’re associated with something innovative or useful in the real world. What Lewis’s book demonstrated to me isn’t just how “bad” HFTs are per se, but rather, what happens when finance keeps walking down the path it seems to be set on — a path that involves abstracting itself from the creation of real-world value. The final destination? It will enter a world entirely of its own — a world in which it is fighting to capture value that is completely independent of whether any is created in the first place.