Michael Santoli

No, the stock market isn't 'rigged.' A primer on speed trading

Life is too short to waste time worrying over computer traders that sift the stock market for pennies with millisecond maneuvers.

The phenomenon of “high-frequency trading” has gone from obscure cyber-nuisance to popular phantom menace in recent days. Credit or blame the release of Michael Lewis’s book on this Wall Street subculture, called “Flash Boys,” and his comments in a 60 Minutes segment Sunday that the stock market is “rigged” against ordinary investors and in favor of predatory software fraudsters exploiting arcane trading rules and enormous computing power for easy gain.

This burst of media focus on the electronic scrum that occurs in suburban server farms was followed Tuesday by news the FBI is investigating potential insider-trading violations by unnamed HFT players who might have acted on information slightly ahead of when it becomes public to most investors.

These storylines reinforce an abiding mood of public suspicion toward Wall Street institutions one stoked in the tech bust more than a decade ago and fed potent fuel by the credit fraud and recklessness behind the 2008-’09 financial crisis.

Yet the narrative of crooked computer sharpies feasting on the retirement accounts of grandma is simplistic and mostly wrong-minded. While certain HFT practices are of questionable value, and all unfair information advantages should be eliminated, here's a bit of perspective on this issue.

While the U.S. equity market is maddeningly convoluted and open to all sorts of loophole-seeking gamesmanship, the fact is that, for small investors, trading stocks has never been cheaper, faster or fairer. Meanwhile, the middleman profits collected by HFT players are a fraction of their peak a few years ago and represent a trivial cost for investors as a whole.

Consulting firm TABB Group estimates that total HFT revenues – not profits, but revenues – declined to $1.3 billion last year from a peak of $7.2 billion in 2009. That’s a trivial number in a U.S. equity market in which more than $200 billion worth of stock turns over every day, according to estimates by Sandler O’Neill.

Q: How did we get here?

A: With a series of rule changes in the early part of the last decade, the Securities and Exchange Commission sought to promote competition among exchanges and accelerate the move to electronic (versus human-based) trading, in order to reduce the bid-offer spreads on stocks and deliver the best available share price to public investors. These efforts were partly in response to scandals in which market-makers in Nasdaq stocks and floor traders on the New York Stock Exchange were found to be colluding to set spreads and guarantee themselves lush, riskless profits.

This policy push worked in the simplest terms. We now have dozens of exchanges, alternative trading systems and “dark pools” – private networks where large fund managers can trade directly among themselves. They compete furiously to attract order flow and jockey to lure opportunistic trading firms that in turn try to offer competitive quoted prices.

Trading spreads and commissions have collapsed, and a small investor buying a small number of shares through a discount broker gets an instantaneous confirmation at the “national best bid or offer” – the optimum price available at that moment. All for about $8 a trade, a fraction of what a small fry would have paid 20 years ago.

 Q: So what’s the problem?

 A: This competitive frenzy combined with ever-faster technology systems and data-analysis capabilities to propel an arms race that privileged speed and encouraged waves of rule changes and new order types meant to give incentives to electronic middlemen to participate in trading.

HFT trading houses emerged from this trend. They wrote elaborate computer code to detect fleeting price anomalies and hunt for evidence that large investor orders are being executed. Many began placing their servers physically adjacent to exchange computers, not content to send orders at the speed of light from a few miles away.

These firms can also subscribe to direct-access data feeds and glimpse early indications of large orders being handled by brokerage firms, which can deliver advantages in designing their trading tactics. This, to Lewis and other critics, can amount to legalized front-running of customer orders – all in the name of inviting 'liquidity providers’ to the trading arena.

Q: What is the FBI looking into?

A: It appears the inquiry is part of the agency’s larger fight against insider trading, which has already led to convictions of traders who acted on nonpublic corporate information. In this case, the FBI is reported to be examining whether HFT firms improperly receive important information about economic data releases or other investors’ orders. (Some economic data is released to HFT players over expensive “algorithmic news” services in which the news is beamed from one computer to another, to be traded upon before a human investor could receive and read it.)

Q: How big a problem is it?

A: In dollar terms, not very.

Critics decry this as an inherently unproductive exercise, in which a frictional “tax” on stock trading levied by speculators forces “real money” investors to spend heavily in defense of their clients’ interests.

This is true in the abstract. But markets have always included pure speculators trying to “read the tape,” and some class of participants always operated at the “highest frequency.” The first firms to have access to undersea telegraph signals, phone lines and mainframe computers had an advantage for a while.

If anything, the profits accruing to these “unproductive” middlemen are lower than at any time in history. The pure stock-trading units of large brokerage firms operate at low profit margins. The exchanges make most of their money trading futures and options, not stocks. Commissions for institutions and individuals have collapsed, mostly due to the very competition and technology that  enabled HFT.

There was a gold-rush moment for HFT when these players had a big technology advantage, exploited new order-handling rules and fed on wildly volatile stock prices in the crisis years. But that moment passed, and this activity has faded in size and importance in recent years.

And, crucially, the small investors who might be most alarmed by the scary-sounding cyber-predator hype are the ones who have it easiest these days in trading cheaply and securely, as Reuters’ Felix Salmon notes here. For TABB Group's expansive rebuttal to Lewis' take, see here.

Q: So is Michael Lewis raising false alarms about a sound market?

A: It’s not entirely sound. There are plenty of areas that could be improved.

If one were starting from scratch, no one would build the system as it exists today, with so many trading forums operating under differing regulatory mandates, dozens of order types, fragmented order flow and an over-reliance on electronic players who are under no obligation to smooth out trading in times of extreme market stress. We basically have the same market arrangement that underwent the still-misunderstood one-day “flash crash” meltdown in 2010.

The enormous waves of quote traffic that get cancelled every second of every trading day – reportedly a focus of the FBI inquiry – certainly seem to represent robotic gamesmanship that risks tipping over to outright manipulation.

And any allowance for privileged access to market data should be closely examined on grounds of fairness and effectiveness in promoting actual liquidity, rather than simply providing a peek at profitable information to the highest bidder.

Yet the noise and outrage surrounding the HFT issue far exceed the apparent inefficiencies or abuses in the system.

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