Applying the Brakes to Super-Fast Trading

“The United States stock market, the most iconic market in global capitalism, is rigged”, said Michael Lewis on “60 Minutes”. The perennially best-selling author was promoted his latest book, “Flash Boys”, which tackles the subject of high-speed trading.

It’s a topic we dealt with a year and a half ago in this article, when inadequately vetted code at trading firms or exchanges had caused a trio of market plunges such as the 2010 “Flash Crash” in which a market drop of 300 points in the Dow set off a computer-driven selling frenzy that caused a plunge of 600 more. The market recovered within minutes, but the alarming volatility of these crashes was thought to be driving individual investors from the market, a market that has become computerized trading. It now accounts for over half the daily volume of stock trades. We voiced “growing concerns that high-speed trading is manipulating the markets” without knowing quite how. Neither did anyone else, until — as recounted by Lewis — an executive at the Royal Bank of Canada cracked the code.

Lewis' book and "60 Minutes" interview caused an immediate sensation. The allegation that high-speed trading causes the market to be “rigged” has triggered investigations by the FBI, the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission and the New York State attorney general and sent The Street and its supporters into a defensive crouch. The Wall Street Journal resorted to irrelevance in a lead editorial that celebrated the much lower commissions “mom and pop” pay thanks to electronic trading rather than “handing over hundreds of dollars to a well-fed broker in a wood-paneled office”. Much lower commissions owe to the abandonment of fixed commissions way back in 1975, and the efficiency of electronic trading is a triumph well apart from its abuse by high-speed traders. The SEC is the culprit, said the editorialists, not the perpetrators.

They refer primarily to the SEC rule that requires a trade to seek the best price among the 13 exchanges whose server installations dot the map of New Jersey as well as some 50 alternative trading platforms. That buy or sell trades travel over fiber-optic cables to the principal exchanges means that the shorter the route, the quicker a trade reaches an exchange in order to grab that best price before another order gets there first and moves the price up on a buy or down on a sale. To get there first, high-speed trading firms began years ago to pay extra to the exchanges to place their order-processing boxes right on their premises — claims of unfair advantage to no avail.

The “60 Minutes” piece reported that one outfit named Spread Networks had spent $300 million to lay a fiber optic line from the futures market in Chicago to the New Jersey exchanges just to shave 3 milliseconds off the departure and arrival time and were leasing access to high-frequency traders at $10 million a customer.

Not fast enough for another Chicago firm, Anova, which will link the New York Stock Exchange installation in Mahwah, New Jersey, to Nasdaq’s facility 35 miles away by laser communication. Only the speed of light will do in the “race to zero”.

None of this is news. What broke new ground in Lewis’ tale was the discovery by the head of stock trading in the New York offices of the Royal Bank of Canada named Brad Katsuyama that, to use a buy order as an example, high-speed traders are able to leap ahead of an order as it wends its way across New Jersey looking for the best price, buy the shares at that best price before the original order finds it, and then sell the shares to the original order-placer at a higher price, pocketing the difference. What set Katsuyama on his quest was that, over and over, when the bank’s traders placed a client’s buy order for a large block of stock, the order would only be partially filled, and the rest of the order would go off at a higher price.

What Lewis also brought to light is a practice employed by brokerages that is practically unknown to the individual investor called “payment for order flow”. Instead of placing your orders with the exchanges, large brokerages sell them to companies outfitted with super fast computers that — unaccountably, given the SEC’s best price rule — match orders internally with the other customers of all their client brokerages without ever going to the exchanges. These shadow companies are said to make their money on prices differences on trades but just what they do seems to be opaque. The Journal reported that the stock price of Charles Schwab, E*Trade Financial and TD Ameritrade had “tumbled” in the wake of the “Flash Boys” exposé out of concern that these brokerage firms would lose “hundreds of millions of dollars a year” paid to them by these intermediaries should the practice be banned.

When over a year ago Mary Jo White appeared before the Senate for her confirmation hearing as chair of the SEC, she said that appraisal of the impact of high-speed trading on the markets would be a "very, very high priority" and spoke of a "sense of urgency". Yet here we are with nothing done and Michael Lewis way ahead of the government. She now says, "I think you really do want to do a soup to nuts review" that begins with the assumption that "the markets are not rigged".

So, taking stock, so to speak, what do we have here? A parallel universe of higher-frequency and higher-speed traders than the rest of the market, more than doubling the volume of the market every day with blizzards of in and out trades. And not even actual trades, necessarily. A high percentage of that volume is simply feelers — trades put on the wire only to discover the buy or sell price ahead of everyone else, but instantly canceled. These companies jump the line to get ahead of everyone else, siphon away money, adding no value and serving no public good. "Computerized scalping” in Lewis’ phrase.

It is in the market's best interest to cut the pointless traffic, and the surest method is a tax on trading, which was the solution we arrived at in our previous article in October 2012. With shabby tactics newly laid bare by the Michael Lewis book, that proposal has come up. A tax on trading is nothing new; John Maynard Keynes once proposed it. And there was a transfer tax levied on sales by New York until 1981 (rather, it is still imposed and — words fail — refunded back to the brokers that paid it).

Trouble is, a tax on all stock trades is what is always broached, which would penalize everyone for no explicable reason unless it is to guarantee that no legislature will touch it. Clearly, as we put forth originally, any tax should be based formulaically on the volume of trades launched daily by a firm, and engineered to be zero for the typical banks, brokers, hedge funds, etc. trading at human speed and in human quantities.

The effect would be miraculous: plenty of money raised at the outset as a penalty for the burden imposed on order flow and the exchanges, quickly followed by greatly reduced volume when the high-speed traders realize how much their manic frenzy is costing them. But market manipulation seems to be a topic that flares up now and again, then fades, with nothing having been fixed, and that has left individual investors with the belief that this system, too, is rigged against them.

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