Stock image: the New York Stock Exchange reopens after the Easter holiday, 21 April. Photo: Getty
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HFT: the latest scam devised by Wall Street and the City

Felix Martin discusses Flash Boys by the American financial writer Michael Lewis, which examines high-frequency trading (HFT).

Flash Boys, the new book by Michael Lewis, America’s explainer- in-chief of all things financial, is an account of “high-frequency trading” (HFT) – a technique developed by financial firms that deploys vast computing power to trade electronically on the world’s stock exchanges at extreme speed.

That may sound pretty esoteric. However, the book is generating an enormous amount of attention because it argues that HFT is the latest in the litany of scams that Wall Street and the City have devised to relieve unwitting investors of their money.

Whenever you hit Enter to buy shares through an online brokerage, Lewis shows, your order does not go straight to the stock exchange as you might think. Instead, HFT firms get a look-in first – and they use their superior speed to “front-run” your order by buying the shares ahead of time and then offloading them into the market at a marginally higher price. The resulting profits are tiny on any individual order but they run into the billions when you add them up. And they are made at your expense. Given how many people have a stake in the stock market these days with their Isas and their Sipps, this is certainly a disturbing revelation. Lewis deserves all the praise he is getting for exposing it.

Yet, to my mind, Flash Boys is even more important than this. For it exposes HFT as a prime example of one of the major problems of our age: the unintended consequences of technological innovation. Technologists, regardless of their political bent, tend to be idealists – it probably requires a healthy dose of idealism to take the risks required to innovate. But all too often, idealism can slip into naivety. The unstated assumption is that if new technology can be used to better the lot of the individual, it will. Everything will be OK so long as you “don’t be evil”.

Unfortunately, it doesn’t always work like that in the real world. The new technologies developed by well-intentioned young geeks in Silicon Valley and Old Street get grafted on to an economy that is still dominated by big, profit-seeking corporations run by shrewd old-economy dinosaurs. Innovation is driven by the admirable belief that new technology is a tool for the emancipation of human creativity and self-fulfilment. Less thought is given to what might happen after, say, News International buys your app.

The point is more general than just the compromises that come with commercialisation by big business. What the technologists are missing is the crucial importance of the social context in which new technology is deployed and, above all, the role of that most reliable of social scientific regularities, the law of unintended consequences.

The canonical problem is that we design some new technology to solve a problem but in doing so we make a crucial assumption: that everything else will remain unchanged and in particular the way that people interact, the social context, will be unaltered. What happens is that behaviour adapts. The technology succeeds – the old problem is eliminated – but new problems arise.

An example that is almost guaranteed to have infuriated anyone reading this at some time or other is the computerisation of personal credit scoring. Companies such as Experian or Equifax apply information technology to the problem of deciding who should and should not get loans.

In an economy where mortgages and mobile-phone contracts are considered essentials, the decisions that their computers churn out are important. Their claim is that their algorithms are not just cheaper than the Captain Mainwaring-style bank manager of old but also more objective and therefore fairer.

If it were true that people’s behaviour had remained constant after the introduction of computerised credit scoring systems, that might be the case. But in reality, people game the system. Personal finance articles and chatrooms warn them that cappuccinos and city breaks flag them for a downgrade, so they take a breather for three months before applying for a mortgage – and then they start up again as soon as the ink on the contract is dry.

It is no different from the snag that the Soviet Union discovered with a planned economy. You could solve the problem of low productivity – at least as the bean-counters captured it – with more demanding targets. The underlying disease of demotivation proved more resilient, however. As an aphorism of the period had it: “They pretend to pay us and we pretend to work.”

The story that Lewis tells of HFT is a perfect example of the law of unintended consequences at work in the technological transformation of the stock market, one of the most basic institutions of our capitalist economies. The computerisation of stock exchanges that began in 1986 promised to make them simpler and more efficient. The world of barrow-boy traders bellowing at one another in the pit and the old-boys network of City stockbrokers was abolished in favour of anonymous electronic trading on a virtual exchange.

The intention was to stop investors being ripped off by an uncompetitive industry. However, this assumed that behaviour would not adapt. The stockbrokers and pit traders did hang up their red braces and garish blazers but a new generation of rent-seekers emerged in their place. As Flash Boys documents, the fixed commissions levied by the stockbrokers of yesterday were replaced by the cuts taken by the HFT firms of today.

So, what is the lesson to be learned from Lewis’s latest blockbuster? Well: this past week, the government’s ambassador for digital industries announced that schoolchildren should learn less French and more code. Maybe. But the lesson of the burgeoning HFT scandal is that the naive application of technology can be a uniquely dangerous force. We should be teaching our budding technologists not just code – but the law of unintended consequences.

Macroeconomist, bond trader and author of Money

This article first appeared in the 14 April 2014 issue of the New Statesman, Easter Double

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Cabinet audit: what does the appointment of Andrea Leadsom as Environment Secretary mean for policy?

The political and policy-based implications of the new Secretary of State for Environment, Food and Rural Affairs.

A little over a week into Andrea Leadsom’s new role as Secretary of State for Environment, Food and Rural Affairs (Defra), and senior industry figures are already questioning her credentials. A growing list of campaigners have called for her resignation, and even the Cabinet Office implied that her department's responsibilities will be downgraded.

So far, so bad.

The appointment would appear to be something of a consolation prize, coming just days after Leadsom pulled out of the Conservative leadership race and allowed Theresa May to enter No 10 unopposed.

Yet while Leadsom may have been able to twist the truth on her CV in the City, no amount of tampering will improve the agriculture-related side to her record: one barely exists. In fact, recent statements made on the subject have only added to her reputation for vacuous opinion: “It would make so much more sense if those with the big fields do the sheep, and those with the hill farms do the butterflies,” she told an audience assembled for a referendum debate. No matter the livelihoods of thousands of the UK’s hilltop sheep farmers, then? No need for butterflies outside of national parks?

Normally such a lack of experience is unsurprising. The department has gained a reputation as something of a ministerial backwater; a useful place to send problematic colleagues for some sobering time-out.

But these are not normal times.

As Brexit negotiations unfold, Defra will be central to establishing new, domestic policies for UK food and farming; sectors worth around £108bn to the economy and responsible for employing one in eight of the population.

In this context, Leadsom’s appointment seems, at best, a misguided attempt to make the architects of Brexit either live up to their promises or be seen to fail in the attempt.

At worst, May might actually think she is a good fit for the job. Leadsom’s one, water-tight credential – her commitment to opposing restraints on industry – certainly has its upsides for a Prime Minister in need of an alternative to the EU’s Common Agricultural Policy (CAP); a policy responsible for around 40 per cent the entire EU budget.

Why not leave such a daunting task in the hands of someone with an instinct for “abolishing” subsidies  thus freeing up money to spend elsewhere?

As with most things to do with the EU, CAP has some major cons and some equally compelling pros. Take the fact that 80 per cent of CAP aid is paid out to the richest 25 per cent of farmers (most of whom are either landed gentry or vast, industrialised, mega-farmers). But then offset this against the provision of vital lifelines for some of the UK’s most conscientious, local and insecure of food producers.

The NFU told the New Statesman that there are many issues in need of urgent attention; from an improved Basic Payment Scheme, to guarantees for agri-environment funding, and a commitment to the 25-year TB eradication strategy. But that they also hope, above all, “that Mrs Leadsom will champion British food and farming. Our industry has a great story to tell”.

The construction of a new domestic agricultural policy is a once-in-a-generation opportunity for Britain to truly decide where its priorities for food and environment lie, as well as to which kind of farmers (as well as which countries) it wants to delegate their delivery.

In the context of so much uncertainty and such great opportunity, Leadsom has a tough job ahead of her. And no amount of “speaking as a mother” will change that.

India Bourke is the New Statesman's editorial assistant.