The Flash Boys Frenzy

flash boys High Frequency Trading has been in the headlines for much of the spring. In response to this maelstrom, David Damiani, Balentine’s Director of Risk Management and Implementation, discusses Balentine’s approach to implementation and how it differs from the processes currently being highlighted in the media.

At a recent charity event, I tried to bid on several of the silent auction items. It was quite a complex set-up, and bids could be made on mobile devices. Mere seconds after I placed my bid, however, I was outbid by someone who had set his device to automatically bid above anyone else. While not entirely the same, this experience reminded me of the debate surrounding High Frequency Trading.

High Frequency Trading, the process of buying/selling stocks with a holding period measured in micro-seconds, has been the talk of many and is the subject of Michael Lewis’ most recent book Flash Boys: A Wall Street Revolt. By design, High Frequency Traders fly under the radar and practice a very different kind of trading than the high profile group of bond traders in Lewis’ Liars Poker. However, Flash Boys has drawn a lot of unwanted attention and ire toward Wall Street and traders in particular, inciting a media frenzy on the validity of this type of trading.

Whether you consider high frequency traders genuine providers of liquidity or pick pockets is, for now, a moot point, since regulatory authorities currently condone the practice. Therefore, rather than join in the melee, I would like to consider trading more broadly and identify several ways in which Balentine strives to mitigate the “costs” to execute transactions across client portfolios. The costs involved to trade are both explicit and implicit and include commissions, spreads and slippage.

Commissions are a service charge assessed by a broker-dealer or other investment advisors for handling the purchase or sale of a security. Perhaps the most recognizable and transparent cost, commissions range in value from fractions of a penny to many dollars. Typically commissions are measured as a percentage of the total transaction and decline as the order size increases. Balentine has made great strides in reducing this cost to client portfolios by negotiating lower commission rates; on average, the commissions our clients pay brokers to execute trades are well below published standard fee schedules.

Bid-Ask spreads (partially the theme of Flash Boys) are a less-obvious expense but can overwhelm the cost to transact. For example, paying two pennies above the bid (a two-cent spread) to purchase a stock can be far more costly than the aggregate pre-determined commission the broker levies. It is possible for investors to buy stocks on the bid and sell at the ask, effectively neutralizing the spread; however, this is not typical. All else being equal, it behooves investment managers to invest in securities with narrower spreads. One way in which Balentine achieves better spreads is to utilize ETFs. While the ETF itself is exposed to the bid-ask spread, the price spread on the ETF is typically narrower than the collective of all the underlying securities.

Slippage can also impose an unwanted cost when executing a trade. Slippage is the change in the security’s price from the time an order is submitted to the time it is executed (the primary theme of Flash Boys). Ignoring entirely the practice of front running,[1] Balentine attempts to mitigate this cost through

  • Utilizing limit orders, which protect against violent price swings – a la the “flash crash” of spring 2010;
  • Transacting at pre-determined prices, which helps us avoid exposing the order in the public domain; and
  •  Partnering with brokers that work on an agency capacity rather than a principal basis; i.e. they are not transacting with their in-house prop desks.

It is worth noting that bonds are also exposed to costs similar to those outlined above, but those costs are less obvious because there are no bond exchanges. Bond traders are notorious for buying and selling customers’ bonds without charging a commission. Sounds great, right? Not if the bond dealer is “marking-up” the bond price to compensate for his service. While every retailer is entitled to some gross margin, many times the mark-up exceeds the bond’s coupon, thereby eating an entire year’s interest payment (or more). To avoid this unnecessary cost, Balentine deals strictly with bond managers that act in an agency capacity and do not mark-up the bonds. These managers earn a percentage of the bond portfolio managed, which aligns their pay with performance, not the number of transactions.

As the High Frequency Trading debate wages on, some may be tempted to dismiss the allegations in Flash Boys as mere “noise.” After all, what is a penny here or there to ensure market liquidity?  However, as fiduciaries, Balentine is obligated to be stewards of client assets first and foremost. Therefore, we manage these costs, explicit or otherwise, to the greatest extent possible through ongoing conscious efforts to achieve fair and equitable execution for our clients.

[1] Front running is the practice where a broker or market maker transacts before the client to achieve the price the client should have received.  As a fiduciary, Balentine does not engage in front running.

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