There’s nothing quite like knowing you’re getting ripped off, and my blood boiled after reading the book “Flash Boys” by Michael Lewis. It’s another brilliant work of non-fiction covering a topic about which everyone should be informed: high-frequency trading (HFT).
This is frequently in the news lately thanks to Lewis and his great work of investigative journalism. My takeaway is that we, the American people, are once again being ripped off by Wall Street middlemen to the tune of billions of dollars per year. In fact, even as the financial world crumbled in 2008 thanks to the mortgage debacle, with stock values and pension funds plummeting, high-frequency trading volumes were skyrocketing for the cloak-and-dagger firms operating in profitable obscurity.
Basically, HFT is where a firm trading in the stock market has a faster route to the stock exchanges than someone else, such as your investment platform (e.g. Fidelity or Schwab). That advantage is achieved via buying fiber optic cable or “co-location,” where a trading firm literally sets up their server INSIDE the building of stock exchange, paying millions to that exchange for faster access to information than you, I or our investment platform can get. The result is an unfair advantage that bilks us of our money yet earns these high-frequency traders an estimated $20 billion per year. While some companies, such as Vanguard (which I use), say that it reduces the overall cost to investors, that doesn’t seem to be the consensus of Flash Boys or other articles I’ve read about it.
There are 13 registered stock exchanges, such as the New York Stock Exchange or NASDAQ, all of which are for-profit entities. In the years since the traders on the floor that were buying and selling stocks have been largely replaced by computers, wiring and switches transferring stock orders, the footprint of the buildings of these exchanges have grown in square footage. Not to hire more people: to have more space to sell to these HFT firms that want to buy expensive space. We’re talking about millions of dollars to get a millisecond (one-thousandth of a second) advantage over other traders, and far more of an advantage over non-HFT firms.
Why would a HFT firm want to be close to a stock exchange? Here’s where it gets tricky – bear with me. Say an order for 10,000 shares comes out of Manhattan from a big retirement account run through Fidelity for the everyday American. As part of Regulation NMS, which implemented “National Best Bid and Order”, a huge institutional investor like Fidelity must buy the cheapest available shares on the market first, then fulfil the rest of the order elsewhere. The HFT guys have offers out to sell 100 shares of every company on the stock market at any given moment as a way to test the market. For example, say the stock in question is Apple. That HFT firm first sells Fidelity 100 shares of Apple at a price, then uses their speed advantage to race ahead using computer algorithms to all the other exchanges, buy up the stock and turn around and sell at a higher price, turning an instant profit. Think of this as a “gambler” betting on a boxing match that they’ve already seen. Easy to know a boxer is going down in the third round and win big every time!
THIS IS CHEATING. Not “creating liquidity” or any of the other euphemistic drivel applied to this tactic. These HFT firms, which are some of the most opaque in the market today, have been known to brag about being profitable every single day they operate. It’s just fractions of a penny per share being extracted…that EVERYONE in the country, except for these HFT crooks, is paying as a premium on every single trade we do, totaling millions of dollars per day in profit for the HFT schemers. A devious fiber optic robot dipping into every pocket and transferring it to silk-lined trouser pockets in New Jersey.
The book centers around a stock trader from the Royal Bank of Canada, Brad Kutsuyama, who learns he is being ripped off and goes on a search to figure out why. After years of investigation, he leaves his lucrative job and assembles a crack team of traders and tech wizards to create his own stock exchange, IEX, with the stated goal to deliver a fair and level trading environment. It has been a race to go fast for these HFT traders, with companies doing things like building a $300 million fiber optic line straight from Chicago to New York even if it meant tunneling straight through limestone. All to get a TWO millisecond advantage on the markets. IEX literally coils miles and miles of fiber optic cable in a box to slow down the signals from HFT firms, winning the speed race by going so slowly that the HFT punks lose their purchased advantage. This levels the playing field for anyone who wishes to place a trade. (I’ll leave it at that, check out the book for more detail if you’re interested.)
The most infuriating thing about this for me: Even with a stock exchange like IEX as a proven way for a trade avoid exploitation by HFT, and with big institutional investors asking their brokers and banks to fulfill their orders through IEX, it’s not happening. Why? Inertia, to some degree. And unclear, yet certainly lucrative, relationships between big companies like Goldman Sachs and the exchanges that pay them spiffs and other incentives to trade with them. Goldman could change things around practically overnight by placing orders on a fair exchange, but so far it isn’t happening to a very large degree.
High-frequency predatory trading such as the above is a bad thing that needs to be stamped out. It is a drain on the economy and is not contributing anything to the world. Instead of competition, launching new stock exchanges merely gave high-frequency algorithms more ways to take advantage of speed they purchase. At the time of this writing, IEX is the only exchange built around delivering a fair price that doesn’t offer incentives or co-location services to the HFT firms. It only earns income from a flat fee per trade, the way it should be!
The SEC, regulator of Wall Street, is not going to keep the sharks and their shredding teeth out of our trades. Regulators are too slow. So what can we, the ordinary investor, do to stop high-frequency trading? Take matters into our own hands and let capitalism and social media be our solution. Go to IAmAnInvestor.org and share the truth about how we’re all getting ripped off, or sign this petition. Ask your brokerage to execute your trades on a platform like IEX, where you are able to honestly exchange shares of a company for the real price and not get gouged. Hopefully the “Flash Boys” story will result in enough public outcry that the companies holding our retirement and trading accounts will pay attention and use their financial sway to do the right thing.