Front-Running: A Thing of the Past

This Friday, IEX will begin trading as an official exchange, marking the end of one chapter of its story and the beginning of another.

"Story" is a fitting word, as it was a book by famed author and journalist Michael Lewis that initially pushed the firm into the spotlight. "Flash Boys" documented IEX CEO Brad Katsuyama's frustration as a trader at the Royal Bank of Canada (RBC) in dealing with high-frequency trading (HFT) and his determination to change the way the markets operate by setting up his own trading venue.

The book became a lightning rod, leading to heated debates and causing regulators to take a deeper look at the world of HFT and dark pools.

So how have things changed since the book was published over two years ago? It depends on who you ask. Some will say everything is the same, and that the markets are still rigged. Others will say there was never an issue with the markets at all, and Lewis' book was a false narrative. Many will fall somewhere in between.

And while everyone in the space seems to have an opinion on the book one way or another, facts seem to be a bit harder to come by. That's not a shot at "Flash Boys," but more of an overall observation of the type of conversations that usually take place about the book ("The markets are rigged! All HFT is bad!" "Michael Lewis is a hack! That book should be listed as fiction!")

Real Report

That's why a recently published paper by Robert Bartlett and Justin McCrary, two professors at the University of California, Berkeley, caught my eye. The paper, entitled "How Rigged Are Stock Markets? Evidence from Microsecond Timestamps," used timestamps provided by two Securities Information Processors (SIPs) to analyze latency for quote and trade data for stocks within the Dow Jones 30 between August 2015 and June 2016.

The results found that liquidity-taking orders actually gain an average of $.0002 per share when using SIP-reported national best bid or offer (NBBO) instead of those pricey direct data feeds from exchanges.

"Trading surrounding SIP-priced trades shows little evidence that fast traders initiate these liquidity-taking orders to pick off stale quotes. These findings contradict claims that fast traders systematically exploit traders who transact at the SIP NBBO," the report states in the abstract.

I strongly urge you all to read the paper, as it's fascinating and disruptive to what many of us believed were established truths, but the crux of its conclusion is this: Front-running does not exist in the current market. Naturally, this challenges the long-standing belief that HFT firms get out ahead of bigger retail firms and increase their spread ever so slightly due to their speed and direct market data feeds.

Something that the paper does note, and is important to reiterate, is the fact that the analysis only started in August 2015. In short, just because front-running doesn't exist now doesn't mean it didn't back in 2014. 

A lot can happen in two years, and while regulators aren't always the quickest to act, that tends to change when a best-selling books labels the entire system rigged.

Generalization

The report was first published August 5, but if this is the first time you're hearing about it, I'm not surprised. There has been little, if any, media coverage of it. 

And to be honest, I get it. The narrative of a slimy, sneaky HFT firm reaching into the pocket of Average Joe's 401K and skimming money off the top every time he makes a trade is easy to tout and quickly gets people riled up.

I'm far from a HFT apologist. There are certainly HFT firms out there with predatory tactics. But the same could be said for every occupation in the world. There are bad teachers. There are bad cooks. There are certainly bad journalists. That's doesn't mean teachers or cooks or journalists are inherently bad people (I could be wrong on that last one).

So in a world where too often people are keen to let their uninformed opinions fly when it comes to HFT (I include myself in this group), it's nice to see a something solely based on the numbers.