“Believe me, nothing except a battle lost can be half so melancholy as a battle won.” – Arthur Wellesley, Duke of Wellington, following his victory over Napoleon at Waterloo (1815)

The Battle of Waterloo is best known for Napoleon’s last stand against the British under the command of the Duke of Wellington.  While the military and political ramifications of Waterloo populate the history book headlines, it is also a secondary tale of the power of speed – and the competitive pursuit of an information advantage in the markets.

In the early 1800s, news traveled at a painstakingly slow pace.  There were few organized courier services, the telegraph was a conceptual laboratory project, and roads were often little more than carved-out, horse-drawn cart paths.  As a result, news from around the world could take weeks or even months to arrive in a local market – and by then, those deliverables were, naturally, highly anticipated events.

The world’s preeminent financier at the time, the Baron Rothschild, had long understood the value of getting information through accelerated communication channels. In response, he built a network of field agents, fast courier ships, and trained carrier pigeons to outrun the established communications of the day.

As historian Niall Ferguson notes, the arrival of Rothschild’s carrier pigeons in London with specific battle results from Waterloo – a full day ahead of the broader news flow – created an interesting and advantageous opportunity for the Baron and his financial empire.  While the specifics of his actions from that point on have long been lost to history, they exemplify the power of using a superior communications network to effectively front-run the markets – and an example of true insider information.

The financial world has come a long way since those quaint days when the speed of a carrier pigeon decided one’s economic fortune or demise.  Electronic trading specifically has improved the speed, efficiency, record keeping and the liquidity of the markets and, importantly, has substantially lowered transaction costs over the last several decades.  It was only a generation ago that blue chip stocks traded for a ‘quarter’ of a point spread ($0.25 per share) and was accompanied by a hefty full-service brokerage commission.  Today, in large part due to electronic trading, competition among exchanges, and scale, that same blue chip stock is traded for a spread of a mere penny and can be purchased for a de minimis commission.

But technological advance, unchecked and poorly regulated, should be examined – which brings us to the topic of the piece:  High Frequency Trading (or HFT for short).  HFT is hardly a revolutionary concept, having been around since at least the late 1990s. It encompasses a range of strategies from the positive ‘passive market making’ to less sanguine ‘rebate arbitrage,’ ‘momentum detection,’ ‘order flow detection,’ and ‘latency arbitrage.’  Just like the labels on your pre-packaged foods, you inherently know that most of these trading strategies might not be good for you.  Each one is created to make money by getting there first, jumping in front of slower investors.  But are they ‘front-running’ in a traditional ‘insider information’ sense or in the aggregate are they providing liquidity and price improvement to investors?

For instance, the graphic to the right depicts two trading execution time lines over the course of a single second.  The red line ‘gets there first’ and presumably is able to sell to the blue line a couple of micro seconds later.  At first blush, we could conclude that there isn’t a lot of value creation from this red line interloper, except of course for the owner of the red line.  But in the big picture, has HFT created more value in the system than they are extracting as compensation?

While on the margin they are not completely harmless financial middlemen, electronic trading strategies have provided liquidity and price improvement to the market over time.  The ability to purchase a 100 share lot of a $50 stock for a penny spread instead of a 25 cent spread has put an incremental $24 into an investor’s wallet ($0.24 difference x 100 shares).

Without a doubt, this democratization of the markets, fueled by electronic trading, has fundamentally challenged the economic pillars of Wall Street and has resulted in a significant transfer of economics to the individual investor over time.

In addition to the controversy around the front-running issue, there is also a question as to whether HFT has potentially introduced yet-understood risks into the market structure.  For example, both algorithmic and HFT trading were found to have contributed to the volatility in the May 6, 2010 Flash Crash, when high-frequency liquidity providers rapidly withdrew from the market.  While it is difficult to know if HFT has made trading inherently more unstable and prone to sudden unexplained crashes, we do know that the Flash Crash and any perceived ‘rigging of the markets’ have eroded investor confidence over time – and that is not good for anyone.

Yet HFT has become pervasive in the daily lives of investors, and now accounts for anywhere between 60%-70% of total market volumes over the last few years.  Indeed, HFT – and so-called ‘dark pools’ (a separate and equally ambiguous topic) – have become so embedded in our modern trading structure that getting rid of them is likely to be far more complicated than one might expect without a grand reset on the rules around execution.  While it is shaping up to be a real challenge for regulators, legislators, and enforcers to reconcile where the ethical line is drawn between the need for competitive, well functioning markets and the protection of the individual investor, our view is more pragmatic.

Sand Hill Global Advisors manages long-term investment strategies.  In speaking with our custodians, we believe that at most, the impact of HFT on your portfolio may be a couple of pennies per year.  We are your fiduciary partner, seeking the lowest cost implementation and trading costs possible for the best possible long-term results in your portfolio.  Historically over time, that approach, combined with the bigger picture electronic evolution of the markets, has translated into better investment performance and satisfied clients – our ultimate goal every day of every week of every year.

In the wake of the current controversy created by Michael Lewis’s book Flash Boys, the debate around whether the use of high-speed trading technology is simply keeping to the letter of the law but avoiding the spirit of the rules has drawn a lot of attention.  But the answer is far more ambiguous than conventional wisdom depicts.

Understandably in the moment, just as the Duke of Wellington may have lamented his win at Waterloo, the individual investor may see HFT as a melancholy victory. But in the context of the wider generational evolution in the efficiency of the markets, it may be a small price to pay for the benefits that have accrued to investors over time.