An Interview with James Angel

In this interview for the High Frequency Trading Review, Mike O’Hara talks to James J. Angel, Associate Professor of Finance, McDonough School of Business at Georgetown University and author of a number of papers on the structure and regulation of financial markets, including “Fairness in Financial Markets: The Case of High Frequency Trading”, which he discusses here.

High Frequency Trading Review: James, your paper “Fairness in Financial Markets: The Case of High Frequency Trading” was originally published towards the end of last year, I believe. What kind of response have you had to that paper? Have you had much feedback from people specifically regarding the fairness (or unfairness) of HFT?

James Angel: I haven’t had a lot of direct contact with people saying, “I read your paper and this is my opinion on it”, but I have had numerous conversations with people. Those who understand trading & understand the business generally see that it makes sense, but there are a large number of people out there who trade but don’t really understand trading. They have this sort of visceral fear that somebody is “sticking it to them”.  Out of their ignorance they blame the people who use computers to trade, because of this false meme going around that high frequency traders get an advanced look on their orders before anybody else does.

I hear that from so many people, I think it’s really important for the industry to get the message out about exactly what is going on here and to point out that people have been using computers to trade for decades. But ever since the first computer was hooked up to the market, we’ve had this fear that the computer is eating the universe, like in bad sci-fi movies of the 50′s!

HFTR: Is that what prompted you to write and publish this paper in the first place? The fact that there are so many misconceptions out there?

JA: Well, in much the same way as there used to be “Kremlinologists” who followed what was going on in the Kremlin, I’m kind of like an “SEC-ologist”. I’m an academic nerd and I study the nuts & bolts of how the markets operate.

That’s highly affected by regulation. Last year the SEC put out a Concept Release and over and over again they kept asking, “Is this fair, is that fair?”. So it started me thinking, what exactly does it mean for financial markets to be fair? It’s not as if there’s a crisp definition in our Securities and Exchange Act about what is a fair market. The bottom line is, fairness is a lot like art and pornography. We know it when we see it but it’s hard to pin down.

HFTR: In what way?

JA: If you look at the dictionary, you’ll find a number of different definitions for the word fair. One of them is as in a trade fair, where different vendors get together and engage in business. That’s rather interesting because when there’s a lot of competition in a market, you generally have arrived at a good (or a fair) price.

Sometimes fair means good looking, as in she had a fair complexion. At other times, fair means mediocre, i.e. your grade is excellent, good, fair or poor. But I don’t think Congress is saying we want a mediocre and orderly market.

What I think they mean by fair is really an equitable market. But what does it mean to be equitable? Because there are two approaches to being equitable. One is equal opportunity, that is everybody plays by the same rules, everybody’s treated the same way. I think most people who understand the markets would say that the same terms and conditions should apply to everybody.

The other approach is fairness of outcome. The disturbing thing is that the tone of the SEC Concept Release was looking more at fairness of outcome rather than fairness of equal opportunity. They are asking questions along the lines of, “is it fair that people spend resources to develop an advantage in the market?”

HFTR: Why do you find that disturbing?

JA: Since the financial meltdown, there’s been a lot of revisiting of the ethical & moral basis of our financial markets, which is not in itself a bad thing; it’s good to revisit the basics from time to time. Personally, I think our financial markets do an incredible number of really good things and that many of the moral criticisms are ill-founded. I also think it’s necessary to go over this “tired old ground” so to speak, because for centuries (probably millennia if we go back far enough) there has been this deep-seated populist mistrust of the financial markets, of the money changers, of the banks. And whenever there’s a financial problem, this mistrust comes back again.

But you would expect the regulators to have an understanding of the markets. So when the SEC started asking “is it fair that people spend extra money to sit their computer right next to the stock exchange computer?” it really showed an almost shocking ignorance of financial history. Why did people buy a seat on the NYSE floor? It was to get closer to the scene of the action. Why did brokerage firms pay extra for real estate right next to the stock exchanges and commodity exchanges? To get their orders in faster.

Consequently, it makes me shudder a little bit when I hear our regulators asking questions like that because I would hope that they would have enough of an understanding of the history of the markets, where they came from and what they do, that they wouldn’t be asking such basic questions.

HFTR: So are you saying there is a fundamental lack of understanding on the part of the regulators, or do you think they are playing politics? Or is it a combination of both?

JA: It’s both, in that the US Congress designed the Securities and Exchange Commission to be a politically very responsive agency. It’s run by a committee of five political appointees and it’s located in Washington, hundreds of miles away from the financial markets they’re regulating. When a senator gets up and starts mouthing off about something, the SEC responds pretty quickly. They have definitely been getting a lot of political pressure about the markets but unfortunately, a lot of the populist pressures have been misinformed. For example, former SEC Commissioner Chris Cox said that his biggest mistake when he was the Commissioner was the short sale ban he introduced. When everything was falling apart in September of ’08, the regulators put on this not very well thought out short sale ban.

As with many of the government leaders’ panic reactions in September ’08, it had just the opposite of its intended action. It signaled, “Gosh we don’t know what’s going on, we don’t understand the markets, we’re desperate to do something that looks good even if it’s totally cosmetic, so we’re going to do something that everybody in the business knows makes no sense whatsoever”. That is one of the things that led to an even further crisis of confidence in the markets.

It’s like the typical scene in a TV shoot-out where there’s a gun battle and the guy has a revolver and he fires his last bullet, then after he realizes his gun is empty, he has nothing left to do but to throw the gun at his enemy’s head! The short sale ban was a clear signal that the government had run out of ammo and that it had no clue as to what it was doing. That in itself made the panic far worse.

Now you see a continuation after the Cox regime went out and the Schapiro regime came in. Now it’s, “Gosh, I’m getting a lot of heat from people who’ve lost money, they’re mad and they’re coming to the SEC, complaining to us about these evil computers”. So they ask, “Is it fair that people spend resources to develop an edge?”. Well, is it fair that tall people have an edge in basketball? Is it fair that an outfit like Fidelity can hire the best type of analysts to develop information about the markets? There are plenty of inequalities of resource allocation out there.

I prefer to view fairness in the sense of does everybody have the same access to the market?  For example our Regulation FD (Fair Disclosure) is where the SEC came in and said if you get certain information, you have to give it out equally to everybody. That’s how we traditionally do fairness. But when the SEC made this shift towards equal outcomes rather than equal opportunities, that was a disturbing thing.

HFTR: OK, but if we look at some of the things that you identified in your report, regarding potential predatory or manipulative activity by high frequency traders, you mentioned things like spoofing, wash sales, front-running and so on. From your experience, how much of that is actually going on and how big of a problem is it? Is it something that is happening more than people realise or less?

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