In “The Financier,” his great novel of American capitalism, Theodore Dreiser describes the thinking of his hero, Frank Cowperwood, who exploited banks, the state and investors. It isn’t wise to steal outright, Cowperwood concludes; that would be wrong. But “there were so many situations wherein what one might do in the way of taking or profiting was open to discussion and doubt. Morality varied, in his mind at least, with conditions, if not climates.”
This observation, in a novel published in 1912, offers a useful way to begin thinking about today’s furor over high-frequency stock trading, an ultra-fast, algorithm-driven process that has mushroomed in recent years. The fires of indignation were lit in recent days with the publication of “Flash Boys,” a book by Michael Lewis that vividly describes the practice in a depth not seen before. Mr. Lewis has made a startling claim that U.S. stock markets are “rigged.”
He gets some things right. The old image of the stock exchange as a floor of unruly traders shouting and bustling is largely gone. In the past decade, partly as a result of government regulatory decisions, the markets in the United States fragmented into a dozen or more exchanges. The idea was to create more competition. And in some ways, that has worked to everyone’s benefit. Commissions for stock trades are lower than ever, and the spreads — the distance between a bid and an offer — have been driven down; thus, prices are more precise. Bravo for efficiency.
But there have been some other, disturbing trends. Lewis describes the advent of high-frequency traders armed with fiber-optic lines and computer servers located next to, or even inside, the exchanges. With the advantage of speed, measured in milliseconds, these traders can outrun others who are operating at a slightly slower pace. They can spot when one stock is bought at a given price and immediately — literally faster than you can blink — send prices higher and score big gains. Lewis questions whether this is a digital-age version of “front-running,” a prohibited practice of using inside information about a client’s orders in an attempt to profit by trading in front of the client. It may not be as blatant as front-running, but the practice ought to be examined.
Clearly, a new generation of high-frequency traders has figured out how to arbitrage — or exploit — a time advantage, measured in fractions of a second. It seems hyperbolic to say the market is “rigged,” as Lewis claims. But it is possible that the digital revolution has created a new environment — a different “climate,” as Dreiser put it — that is giving rise to questions about fairness and legality. We hope that investigations now underway will not only determine whether high-frequency trading has stepped over a legal line but also shed light on what, exactly, is happening in this black box of our economy. We can’t slow down technology, but we should insist on rules to keep markets free, open and fair.