In 2012, investors’ long-harbored suspicion that the stockmarket was a rigged game became something of a majority opinion.
This year, exasperation over the predominantly electronicmechanics of trading stocks, in which hyper-fast computer algorithms maneuveragainst one another for fractions of pennies collected over microseconds,boiled over. The level of disgust has gotten broad enough, in fact, thatauthorities might be prepared to rethink some of the basic rules and processesdriving the system.
The opaque and complex structure for trading stockselectronically across dozens of exchanges and alternative networks has longbeen justified by industry leaders and regulators as the messy but logicalresult of investor-friendly reforms. Technology has enabled mind-melting speed,unfathomable communications capacity and brutal competition for order flow –all of which have made trading cheaper and faster than ever.
Yet by squeezing out traditional market makers who oncecollected low-risk, protected profits by mediating among buyers and sellers,rules and technology have tilted the power toward “high-frequency traders.” Andin 2012, the fragility produced by so much layered complexity became tooobvious, and produced too many market-jarring failures, to be considered merelythe price of progress.
A List of Failures
In March of 2012, BATS Trading, an upstart exchange thatsees a large percentage of its volume from HFT firms, botched its own initialpublic offering. First unable to process the initial trades, BATS ultimatelycanceled the IPO.
In May, the Facebook (FB) initial public offering wasmishandled by Nasdaq, whose systems couldn’t keep up with the flood of electricorders. Many small investors just mustering the will to wade back into themarket to own a piece of FB were turned off by the fiasco.
Only months later, Knight Capital Group (KCG), a premierelectronic stockbroker and market maker, nearly went under when atrading-software upgrade went rogue and spewed orders without human intentionor limit. Knight is now being acquired by HFT powerhouse Getco.
A process that began in 2000, when regulators and exchangesmoved to quote stocks in pennies -- making it easier for automated scalpers to“improve” a quote by one cent to legally front-run real orders while reducingthe amount of stock behind each bid or offer -- has now agglomerated to a pointthat almost no one is satisfied. A recent publication of the staid New YorkSociety of Security Analysts declared that “public confidence in the integrityof equity trading markets appears to be at a once-in-a-generation low.” This is a trend measured in the nearly $300 billion retail investors have yankedfrom traditional equity mutual funds since 2009.
Do Robots Really Run the Market?
But do the hyper-fast, disembodied trading robots really runthe market for their own profit?
There is some irony in the fact that the public is soembittered about what they believe to be a market rigged against them, when,for most, stock trading has never been easier or less costly. For a flat $8commission, a stay-at-home investor can instantly execute a trade in almost anystock with little noticeable friction. If, at times, an opportunistic algorithmsteps ahead of that order by, say, bidding a penny more and driving the priceup a couple of cents, that charge is vastly less than the 25-cent spread Nasdaqmarket makers used to take on almost every trade. If anything, the smallinvestor is better served by the current trading arrangements than are largeinstitutional investors, whose need to execute large, sensitive orders iscompromised by the software spies’ efforts to step in front of their tradingflows.
Indeed, even the dominance of high-frequency trading, oncesaid to participate in a sizable majority of stock orders, has passed its peak,thanks to competition and lower market volatility reducing their opportunities.Still, somehow the opacity and bloodlessness of theautomated quasi market-makers rankles more, especially when investors are less confidentof unending stock market appreciation than they were in the late 1990s andearly 2000s.
Perception Becomes Reality
The measure of disaffection with today’s marketstructure by both professionals and individuals means that, even if thefinancial impact to the typical trader isn’t onerous, the sour perception initself diminishes market quality and vitality.
And sentiment isn’t helped by the ongoing round-up ofalleged insider-trading conspirators among employees of major investment firms,which has made headlines that prove the authorities are paying attention whilealso hinting to the little guy that investing profits are often ill-gotten.
The good news in all the frustration with our tangledtrading system is a renewed focus on rationalizing it. At a Senate BankingCommittee hearing on electronic trading in late December, a rough consensusamong exchange officials showed a desire for Congress to lay out clearerorder-handling rules. The recently announced merger of electronic derivativesexchange ICE with NYSE Euronext could provide further impetus for a fresh lookat the trading landscape.
Several years ago, Jim Maguire -- a NYSE floor veteran and longtime specialist for Warren Buffett’s Berkshire HathawayInc. (BRKA, BRKB) shares -- began promoting a small but potentially helpful reform: quoting stocks in minimum increments of nickels rather thanpennies. The idea was to create greater incentive for middlemen to provide adeep and fair market for public orders. Dubbed “Mr. Nickel” by Barron’s,Maguire was viewed as a charming little anachronism. Yet on Feb. 5, theSEC is holding apanel discussion to discuss “the impact of tick sizes on securitiesmarkets.” There is also now a more open discussion over charging high-speedtraders for the massive system capacity they use.
The now deeply ingrained sense that stock trading is a gamerigged by privileged sharpies with their omnipotent machines will not dissipatesoon or easily. But as we enter 2013, it appears at last that those able totake action to foster greater faith in the integrity of the markets are atleast focused on the issue.
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