April 5, 2014 by NS
There’s been a flurry of media attention on high frequency trading recently because of Michael Lewis’ controversial new book Flash Boys. As someone who knows a bit about how financial markets work, this furor is frustrating, because most people don’t really understand anything about the market, yet they have very strong opinions about these matters and spew a lot of vitriol. I thought I’d try to contribute in a constructive way to this by developing an analogy for high frequency trading that is understandable to a layperson and separates the issues in question from the arcane technical details of the market. Though perhaps it’s ambitious to regard this as a “contribution” given my single digit daily readership…
Let’s get to it. Imagine you’re in some rural county, and you need to get some groceries. There’s nothing around but farmsteads, so your only option is to go from door to door seeing what the farmers have and whether they’re willing to sell it. You have to negotiate prices each time, and who knows what each guy has and whether he’s willing to sell at a reasonable price. This is what it’s like to have no market at all. It’s pretty horrible – it takes all day to get anything, you don’t know if you’ll find what you’re looking for, each time you have to guess whether you can get a better price later or if you should just bite the bullet and buy.
Now you come to a small town. There is an open market in the town square. Farmers come to the market when they’ve got something to sell, and shoppers come there to buy. If you’re going for something fairly common, there might actually be competition on the price, as there are several farmers there who are all selling the same thing, and you can find a whole bunch of different stuff in one place. Much better – now you have a market for groceries, albeit one without professional traders. If you try, though, you can still find plenty of stuff to complain about: if you come in the morning, but some farmers don’t show up till the afternoon, you’ll probably end up paying a higher price, and the farmers in the afternoon will have a harder time selling their stuff; due to seasonality and the limited number of farmers, certain goods might be hard to get at some times or very expensive; prices might still change dramatically between the morning and afternoon or from day to day based on who’s shopping and what they need and what the farmers have in stock.
Welcome to ‘Murica! Land of supermarkets! Times have changed – big corporations run everything, stuff is very organized and efficient. Now when you want groceries, you can go to Albertson’s down the street, Shoprite up on Avenue P, or Kroger on MLK Drive. The city is probably called Springfield. The grocery scene is much more complex now – you never see the farmer at all. When you want to buy groceries, you go to a professional trader, who buys and sells groceries constantly. The supermarket gets its supplies from a huge network of grocers and carefully manages its inventory, so you can get the same products all the time, the prices don’t fluctuate so much, and everything is streamlined and mechanical. The selection is much larger, and prices are lower than they were in the good ol’ farmer’s market days. Behind the scenes, the supermarkets are enormously profitable. The farmers are making a living just like they always were, but the supermarkets are so good at managing all this trading activity that they reap a lot of the gains of the improved efficiency, and they are all getting rich like crazy. Hard for the shopper to complain too much, though – grocery shopping is better than it has ever been before.
Now I’m going to introduce you to bizarro-‘Murica. Something weird happens in Springfield. Some dude notices that sometimes oranges are cheaper at Albertson’s, and sometimes they are cheaper at Kroger. He buys a bike and puts together a portable stand. On Tuesday oranges are $3/lb at Kroger and $2.50 at Albertson’s. He buys 20lbs of oranges at Albertson’s, bikes over to Kroger, and sets up his stand in front of Kroger selling oranges for $2.90/lb. It doesn’t take long for him to sell the oranges, because most people don’t want to go to two grocery stores in a day, but they’re happy to save 10c/lb on oranges by buying from the guy’s stand. The guy made $8 just for biking around and trading oranges. Then he buys 15lbs of grapes at Kroger for $4.29/lb and bikes back to Albertson’s where grapes were $5.19/lb. When he puts up his $4.99/lb grape sign at Albertson’s, they go quickly, and he’s another $10.50 richer.
Bike guy starts to get more ambitious and trades more and more products. Anything that people buy a lot of every day is good for him – he doesn’t know anything about farmers or inventory or marketing, so he wants to make sure he can get rid of everything by the end of the day. When you go shopping, things aren’t really any different – you go to whichever grocery store you like, and maybe you get things a bit cheaper from the dude out front, or maybe you just buy in the store as usual. Grocery shopping has gotten a tiny bit cheaper for you, but it’s not really a big difference. But things are about to make a change for the stranger!
Bike guy is doing really well – he hires some help, and some competition starts to pop up. Soon there are a whole bunch of guys out front of each grocery store. They all have just a few of each thing – a couple pounds of apples, a box of Lucky Charms, a bag of generic coffee, two containers of Planter’s peanuts. And they are competing with each other. It used to be that grocery stores priced things by the dime or even dollar. Stuff would be 3.49/lb vs. 3.79/lb or 12.99 per bottle vs. 13.99 per bottle. But these guys are competing down to the penny. There are apples at 3.67/lb and 3.68/lb all around the entrance of Kroger. You never even get into the grocery stores anymore, unless you need something really uncommon, because the guys out front have everything. And things are starting to get weird.
The competition gets really intense among these guys, so they start investing a lot in improvements to their business. Nobody can make money in this business using a bike anymore. They all have state of the art motor scooters that are fast and agile and optimized for getting from one grocery store to another with a load of goods as quickly as possible. They’ve studied all the different possible routes between the stores extremely carefully and have found the best ways, cutting through alleys and such. And in front of the grocery stores, they are constantly jockeying for the best position so that they can be the first to get the incoming customers. There’s a lot of innovation going on, but at this point not much of it is translating into that much benefit for the customer. The prices are a tiny bit lower, and they’re the same at every grocery store. It’s definitely an improvement, but not like the big revolutions of the past.
And you start to notice some crazy behavior when you go shopping. If you’re just buying 1lb of oranges, things are great, but when you are making Italian food for a dinner party of 15 people and you need to get 25lbs of tomatoes, something peculiar happens. You go to the first guy, who has 1lb of tomatoes for 1.43/lb, and buy them. Now you go to the next guy, who has 2lb of tomatoes, also for 1.43/lb, and buy those too. The other guys are all watching you like hawks. Suddenly, all around you, guys start changing their tomato prices from 1.43 to 1.44. You buy 1lb more for 1.43 but by now everyone is up to 1.44. You buy a few lbs more and the remaining guys rush to switch their final 4s to 5s. You were pretty sure there were well over 25lbs of tomatoes for sale at 1.43 when you showed up. But you can’t actually buy them all at that price. When all is said and done, you ended up paying an average of 1.47/lb for your tomatoes. The guys who are really good at detecting when a customer has a lot to buy make more money, because they are quick to raise their prices and end up doing the best sales. The slow guys sell at lower prices and don’t do as well.
And on top of this, what you didn’t see was that all of these guys called their agents over at Albertson’s and Shoprite and told them what was happening, and a flurry of tomato trading went on over there too where the guys who found out first buy tomatoes from the guys who were too slow. They’re not just selling to grocery shoppers, they’re trading with each other as well!
Honestly, it does seem like something has gone wrong. Buying groceries used to be this awesome and simple thing – you’d just go into the grocery store and the prices were all there and it was straightforward. Now nothing is what it seems. You don’t understand what these guys are doing. They know what you’re going to do before you know it yourself. But just out of curiosity, you stick your head into the grocery store to check on the tomato price – 1.49/lb. More than you paid during the little circus out front. What to make of this?
I agree with the sentiment that there is something bizarre and unnatural about this system. But it’s just not that easy to pin down what is wrong with it. The original bike guy was showing the same entrepreneurial spirit and ingenuity that Americans normally value so highly. Nobody is stealing or doing anything dishonest. The arms race to get goods and price information between the grocery stores as quickly as possible is economically inefficient, as it produces little benefit to the world at the expense of a lot of resources, but it’s not illegal to do inefficient things. You actually do pay less to buy stuff than you did back in the simpler days of the plain old supermarkets, and you’ll get the same price no matter where you go. Where in this process do you intervene to prevent the perverse developments? How do you achieve the lower prices without the undesirable side effects?
In the media, no one is interested in these questions. It’s just a witch hunt. But maybe when you think about it in real world language, it’s more clear that this is not a simple problem to deal with.