Last week, my colleague Patrik Löwendahl gave a brilliant presentation on the future of digital business at our annual Digital Tomorrow event. I think that there is a lesson to be learned by other thought leaders from his speech. Without mentioning the buzzword “The Internet of things”, he gave several examples of applications that build on the ubiquity of smart devices that will sense and interact with us and each other. I have to admit that I have heard the same story from Gartner on a recent Customer Strategy event. But, contrary to Gartner, Patrik challenged the audience with a thought-provoking question after each demonstration. His question, “Cool or Creepy”, should be asked more often. In this blog post, I will argue that we tend to be naïve when pushing for digital transformation. We tend to think that the digital business transformation always is driven by the competitive pressure to retain and win customers. Consequently, it is assumed that customers always benefit from the digitalization. In my opinion, that is not always the case and I am concerned that we embrace digital advances without looking at the consequences. I will prove my point by putting the spotlight on the most obscure, most advanced and most profitable winners from the digitalization of the capital markets; the High-Frequency Traders (HFT). I will share the insights that my favorite author Michael Lewis presented in his most recent book, Flashboys, to illustrate the risk that the digital business transformation goes awry.
I guess that everyone that has studied micro economics has read the same article on the economic organization of a Prisoner of War camp during the Second World War. It illustrates how the prisoners fast forwarded our economic history and quickly established an effective market where cigarettes where the common currency and the price for goods where quoted on boards. Similarly, it didn’t take long time until some prisoners started exploiting arbitrage opportunities. They realized that they could buy canned pork cheaply from Jews and then resell them to others at a profit. Though despised by the other inmates, the arbitrageurs filled a purpose in bridging the gap between different markets. In my naivety, I assumed that the High-Frequency Traders (HFT) would fill the same function as the POW arbitrageurs when they emerged in year 1999 as the US Securities and Exchange Commission (SEC) authorized electronic exchanges. When working as a consultant at the leading Investment Bank at the time, I witnessed the explosion of new electronic trading places, Multilateral Trading Facilities (MTF), e.g. Burgundy and Chi-X, at the same time as the banks created their own internal markets that usually are referred to as Dark Pools. Many of us feared that the many trading places would dilute order volumes and increase the spread between the best buy and sell orders and thereby make it harder to provide investors with the best possible price. But, looking at the trading statistics, you get the impression that the HFTs have used their lightning fast computers and connections to create a single virtual stock exchange where the best bid and ask prices are mirrored immediately. Michael Lewis tells another story in Flashboy about some traders at Royal Bank of Canada that started to investigate the flaky market behavior they experienced as soon as they entered orders in their Order Routing systems.
They proved that the HFTs baited the markets by flooding them with small buy and sell orders so that they could intercept any genuine interest to buy or sell stocks. Let me illustrate with an example. An investor asks his broker to buy 10.000 shares in Microsoft at market. The best Ask price is currently $ 40,21. The broker sends the order through his order routing system to the market that is the most beneficial to the bank. The buy order will be matched with the lowest sell-price ($ 40,21) but will only be partially filled with 100 shares as the HFT quickly cancel his remaining sell orders. Next, the HFT will race to the other markets to buy the remaining 9.900 stocks ahead of the investment bank. The race is about milliseconds but the HFT is predestined to win thanks to faster algorithms, dedicated lines and servers that are located in the same data center as the stock exchange. So, when the unfilled investor order finally reaches the markets, the HFT is waiting to sell the investor the 9.900 stocks at higher price, say $ 40,25, and pocket a $ 4K profit without taking any risk. Consequently, the investor has been forced to pay $ 4K more than needed if the HFT had not interfered with what used to be a well-functional market for genuine buyers and sellers.
This electronic front-running does not only deceive the investors. It creates an illusion of a highly efficient market with liquidity and small spreads when all trades are duplicated, orders are entered to lure investors and the thin spread is only an effect of HFTs that want to stand first in line to deceit genuine investors. You really start to question the effectiveness of the markets when you hear that the HFT firms accounted for more than 99% of all orders on the US stock markets but only 50% of the trades.
To me, the scariest part in the story is that all parties on the stock market knew that the investors were getting screwed but did not act, on the contrary, they tried to get a piece of the cake. According to Michael Lewis, the investments banks got their piece by selling access to their dark pools to the HTFs, the exchanges offered co-location and introduced weird order types to win HTF transactions and even the SEC officials were in bed with the HFT firms. The unhealthy linkage between the HFT firms and the regulators at SEC become obvious when the team from Royal Bank of Canada presented their solution to prevent the front-running. They had programmed an order router so that it delayed orders to markets with low latency to ensure that split orders reached all markets simultaneously. The reactions from the officials stunned the team. The officials disapproved and argued that it was unfair to both HFTs and investors that orders were delayed. To them, it was all about speed, regardless of who won the race. Their reactions raise many questions but I settle for one: Cool or Creepy!