How Well Do Futures Markets Limit Manipulation ?

“It’s legalized front-running. I think it is basically evil and I don’t think it should have ever been allowed to reach the size that it did,” he said. “Why should all of us pay a little group of people to engage in legalized front-running of our orders?” –Warren Buffett’s confidant Charlie Munger, CNBC, May 2013 It is interesting that high-frequency traders (HFTs) are often judged in moral terms. Warren Buffett’s right-hand man Charlie Munger referred to them as “evil” in a CNBC interview. A sense of morality even entered one of the arguably most important regulatory documents, the Exchange Act of 1934. Its summary statement in Section 2 talks about the need for regulation in order to ensure “fair and honest markets” (p. 3). As an economist, such statements leave me empty-handed. Who am I to judge “fairness?” And, how can all stakeholders ever agree on what is fair? A much more productive approach to regulation is to simply track transaction cost for various end-users of securities markets. Secondary markets exist to enable trade. They facilitate the re-allocation of assets across (long-term) investors so that those who have the largest appetite for them get to hold them. Trading further leads to price discovery or, perhaps better, value discovery. It ensures that funds get channeled to the most valuable firms, which benefits economic growth. How has the evolution towards electronic markets, and the subsequent arrival of HFTs, affected transaction cost? Retail investors can execute their market orders at a much lower spread today. Institutional investors, however, trade in sizes much larger than the depth available at the best quote. They split their parent order into smaller child orders, and execute them sequentially. They care about incremental price impact, not about the half-spread they pay on a single market order. Ideally, intermediaries lean against their order in the course of its execution. Price impact is minimized that way. Institutional investors worry about the opposite behavior: HFTs who “front-run” them and increase their price impact. Vincent van Kervel and I released a study this summer on how HFTs trade around large institutional orders. We studied how the top-ten HFT firms collectively traded around the orders of four large institutional investors (names below). We analyzed 5,910 orders. A single order was worth about $2 million and led to 135 child trades