The Real Reason the Stock Market Is Rigged

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Everyone's talking about Michael Lewis' latest book Flash Boys and HFT (high-frequency trading) and whether the markets are rigged.

What they're not talking about is how the markets have been set up for institutionalized rigging.

I'm not kidding.

The markets are rigged. You're going to have to get over it and deal with it.

The rigging is in the system and that's just the way it is...

As to HFT, I'll get to that...

But you can't pass judgment on HFT until you understand how cascading technology and unintended consequences landed us in the deep end of the dark pool we now call the market....

And who really set the perfect table for the problem...

First, the Market Got Cloudier

To understand how the market works, which is really easy, you have to understand this:

In the old days the New York Stock Exchange (NYSE) was the stock market.

Buyers and sellers of listed shares used brokers to send orders to the NYSE Floor for execution. And, in the old days, stocks were traded in eighths of a dollar (that came from the old Spanish "pieces of eight" system that cut up silver coins into eighths).

So XYZ stock might trade at $25.00, or $25.125, or $25.25, or $25.375, or $25.50, and so on. You couldn't trade a stock at $25.01, or anything other than in eighths of a dollar.

On the Floor, "specialists" are in charge of every stock. Their job was, and still is, to match up buyers and sellers and "keep a fair and orderly market" as they facilitate "price discovery."

The specialist keeps a "book." It used to be a big leather book; now it's an electronic book. In the book the specialist keeps all the orders he's gotten to buy shares and sell shares in whatever quantity and at whatever price customers are trying to complete transactions.

The specialist used to see all orders for the stocks they were in charge of because all orders had to come to them.

Besides matching up buyers and sellers, specialists can also trade for their own account. That means they can try and make money trading the stocks where they are specialists.

Here's how the specialist makes real money, besides getting paid a tiny fee for matching up orders.

There used to be hundreds of orders in a specialist's book. He knew for example that there was an order to buy 10,000 shares of XYZ at $25, and he saw all the buy orders lined up behind the current buy order. He also sees how many shares are being offered at all the prices customers want to sell stock at.

If the lowest priced order in his book to sell shares was for 5,000 shares at $25.25, and there was an order to buy 10,000 shares at $25, the specialist would "quote" the stock as "$25 by $25.25, 10,000 by 5,000."

Everyone on the Floor near the specialist could hear him call out the quote, and clerks and brokers transmitting information back to their offices knew the quote. They all knew someone, or maybe a few aggregated orders, were trying to buy 10,000 shares and were willing to pay $25.

And that there was a seller, or a few sellers, trying to sell 5,000 shares at $25.25. If neither side budges, there is no trade. The quote can change if a buyer steps up and bids $25.125, or if a seller steps down and offers stock at that price. But if a buyer and seller don't meet at the same price, there is no trade.

Enter again the specialist. He has the book. He might see that there are a lot more buy orders coming in. To make money, because he sees "order flow" is coming into the bid side, he would probably raise the bid himself and try and buy stock at $25.125, ahead of everyone else. If a seller comes down, or a new seller comes in and sells him stock at $25.125, let's say he buys 5,000 shares, he would own 5,000 shares at $25.125.

The key to being the specialist is seeing all the order flow. Because specialists have knowledge of who is buying, who wants to buy and how much and at what prices, and the same is true for knowing the sell side, the specialist essentially gets to trade on inside information.

He raised the bid to $25.125 because he wanted to buy stock there because he knew there were more buy orders coming into his book. If he's right and the stock goes higher, he can sell his position for a nice profit.

If he's wrong (and this is absolutely critical) he was risking one-eighth of a dollar or 12.5 cents per share. His risk is fairly limited because he knows if things change and a ton of sell orders come in (they come to him, don't forget), he knows there is a buyer willing to buy 10,000 shares at $25. So, he can dump the shares he just bought to that buyer and lose only 12.5 cents per share.

Now, re-read that. If you understand how the specialist system works, you will understand exactly how the market works, or doesn't work today. And how HFT works and what's rigged about the system.

The American Stock Exchange was formed to compete with the NYSE. They work off a specialist system too. Then other exchanges sprang up in Boston and Philadelphia. In 1971 disgraced swindler Bernie Madoff formed NASDAQ to trade OTC (over the counter) stocks. OTC stocks weren't "listed" on any exchange, but were traded via telephone by dealers. "NASDAQ" stands for National Association of Securities Dealers Automated Quotations.

Nasdaq is important because it was the first public electronic exchange. A private electronic exchange called Instinet (institutional trading network) began trading in 1969, but was limited to institutions willing to pay for access to each other's bids and offers.

Because Nasdaq consisted of different dealers, there was no specialist system. There was no central floor where all dealers met. In cyberspace each dealer was his own specialist. Each dealer on Nasdaq posted their own quotes for how many shares they wanted and at what prices they would buy and sell each stock they "made a market" in.

More competition came along. This time Nasdaq was the target. Electronic communications networks (ECNs) sprang up. ECNs were and still are networks where dealers who weren't part of Nasdaq could place their quotes and buy and sell with each other. From there it wasn't long before Nasdaq dealers wanted to get onto all the ECNs and demands were made to trade NYSE and AMEX stocks on the computer networks.

That's how technology changed the old specialist system into a mass of different trading venues that now includes entirely new exchanges like BATS, and dark pools where banks and crossing services trade for clients demanding anonymity.

If you haven't figured out the unintended consequences of all this competition yet, you're not alone. The SEC didn't see it coming either...

How the Trail Got Harder to Follow

The problem is that there is no longer any one central place where all orders go to be executed. Orders are spread around based on cost, and services, and, most importantly, "payment for order flow."

To illustrate, let's say you're a brokerage firm like Charles Schwab, or E-Trade, or Fidelity, and you have millions of customers sending you millions of orders, and you don't have your own traders who execute those orders for you. And none of the discount brokerages have their own trading desks. You have to "route" all those orders to some exchange, or some place where they match up buyers and sellers. Where are you going to send them?

In order for exchanges and networks that offer execution of orders to be successful, they have to have orders coming in so they can match up buyers and sellers. Otherwise, if there aren't enough orders to allow matching of buyers and sellers at prices where customers want to transact, that exchange would have no "liquidity" and it would lose business.

So how do all these competing exchanges get orders? They pay for them. They pay Schwab, and Ameritrade and Scottrade for their "order flow." That's right; your order at your discount brokerage is sold to someone so it can be traded on their exchange. Who gets paid for your order? Not you. Your brokerage gets paid.

Stay with me, it's about to all come together and a very bright light will go on for you.

How the Regulators "Improved" Things

While all this competition was spreading out orders across many venues, the SEC decided in 2000 to allow "decimalization."

Starting in August 2000 with seven stocks on the NYSE, culminating in the spring of 2001, all stocks would henceforth be able to be traded in one penny increments. There would be no more eighths. You can now buy a stock for $25.01, or $25.02, or sell it for $24.99.

Here's how the unintended consequences of decimalization along with the unintended consequences of too much competition, meaning the selling of order flow, spawned HFT and the rigging of the markets.

In our earlier example I showed how a specialist could "step in front" of orders on his book to buy stock at $25.125. If he was wrong and the stock went down, he was at risk for 12.5 cents per share for however many shares he bet on buying.

With decimalization, that same specialist can now step in front of the $25 bid and try and pay $25.01 instead of having to pay $25.125. If he dumps his stock because he sees sell orders coming in, and he knows there is still a $25 bid on his book, he is now only risking one penny per share as opposed to 12.5 cents per share.

Of course he is going to trade more for himself. He has less risk. The exact same thing is true for all the "market makers."

Market makers are the same as specialists, except they are mini-specialists in the stocks they trade electronically for their broker-dealer of bank trading desk who trade on Nasdaq or on the ECNs or anywhere where an intermediary can interpose himself into a trade.

When that started happening, which was almost instantaneously with decimalization, buyers and sellers who would otherwise leave their orders on specialists' books or with market makers began to cancel their orders. They realized they were being played.

They saw how their orders were being used by specialists and market makers with inside information (that's what having a book amounts to) to trade against.

Now, most orders, especially big orders, are only put down close to where traders want them executed. They aren't lying around being picked off any more.

Meantime, exchanges and trading venues are buying order flow. Why are they buying order flow? Because they want to create an internal "book" so they can have their own inside information on the order flow, so they can trade against it, or sell it to other traders.

HFT Stepped into the Breach... Created by the Government

HFT is nothing more than taking advantage of the unintended consequences that turned markets into dark puddles of greasy residue of what was once a fair and orderly system.

HFT operators are looking at all the order flow going into all the different exchanges and trading venues they can peer into.

They look into the total flow of orders, which no single exchange can see, and with their empirically modeled time sequencing of orders, spreads, and depth that they run through reinforcement learning algorithms, they come up with a trade that steps in to buy or sell shares before someone who intended to transact there gets a chance to.

Speed is critical to high-frequency trading. Exchanges rent HFT shops space next to their servers (co-location) so they get their data faster than everyone else. That's legal.

The bottom line is, by empirically modeling the aggregate behavior of trading crowds, HFT players can make billions. Again, it's not illegal.

They couldn't do it if they had to risk more than a penny. You can thank the SEC for their "inspired" move to decimalization for that.

They couldn't do it if there weren't so many exchanges and trading venues competing for orders. You can thank the SEC for making that a reality without sensible limits.

They couldn't do it if there was no such thing as payment for order flow; yes, they get paid for their order flow too. You can thank the SEC for allowing that neat little scheme.

HFT shops can buy and sell at the same price (that's a zero profit or loss), but because they provided some venue "liquidity" by sending their super-fast order there to be executed, they get paid.

That's not arbitrage in the traditional sense; that's just playing the game because you know how.

They couldn't do it if they didn't have all the information at the speed they get it at from the exchanges the SEC regulates. Guess who we can thank for that?

HFT's Impact on You...

Are you affected directly by HFT on any trade you make? Maybe, probably if it's a market order. But if you're not counting the loss of a penny a share it may not matter to you, especially if you hold the position for any length of time.

On the other hand, HFT does affect the market, all the markets they play in.

The "liquidity" they say they provide is really volume. High-frequency trading has nothing to do with what liquidity is, what liquidity means to the market. Volume is not liquidity.

Everything's going to be fine when markets are moving up or are relatively stable. We won't really notice HFT. But, in a wicked downdraft, when HFT players turn off their computers, we will see that there are no bids on any specialists' books or parked with market makers. There will be no stopping stocks from falling for that reason.

We saw it in the May 2010 flash crash. That's what HFT has done to the market. It has made it a dark pool, which means one day we could have a catastrophic market failure.

Sure, the markets have fail safes and breakers now, and they would probably recover. But, there's no recovering the trust that once ensured our markets were fair and orderly...

About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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