Start the conversation
Comment on This Story
Or to contact Money Morning Customer Service, click here.
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.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.
Shah's most informative blog of the year to date. Especially the last three paragraphs.
I am not sure if the decimalization has only this negative consequence for the retail investor. The old market makers would take him for 1/8 in and 1/8 out, 1/4 in total and arguably that cost more.
The trading system we have now sets up markets for a big fall and everyone will be caught off guard. And no one, including government regulators, will lift a hand to stop it. Seems we never learn to see problems before they become big problems. Thanks, Mr. Gilani
Shah, why would HFT Traders turn off their computers "in a wicked downdraft"? Are they not able to trade short?
Well herein lies the major problem. The little guy feels less and less comfortable in trusting anything to do with the markets any more. He knows that once the loop is closed here that these guys will find another way to shall we say "be creative" which is simply another word for cheating. The fines that are charged are very small compared to the profits obtained from the fraud so therefor it will not deter it.
Main street is tired of being the fall guy for all this fraud. The little fellow has clearly had enough which is why he parks his/her money in Bonds.
Shah has once again illuminated the underside of the market. A few points of correction, Congress mandated decimalization attempting to reduce the spreads for investors as Ian points out. Also, ECN is an electronic Crossing network. Electronic trading has allowed for some liquidity for investors, it is easier to do a same day or T+1 trade without getting killed on the execution price.
What's interesting about HFT is that the same practice is illegal for an investment advisory firm. Trading ahead, even same day trading is one of those things the SEC can shut you down for!
Actually, Shah is right on both points. The SEC ordered U.S. stock markets to switch to decimals in 2001. And ECN stands for "Electronic Communication Network."
-Dave Zeiler
Actually, Shah is right on both points. The SEC ordered U.S. stock markets to switch to decimals in 2001. And ECN stands for "Electronic Communication Network."
Shah,
Tank you for being so clear about a difficult topic.
Could HFT be stopped very slowly? For example, could he HFT's be permitted to earn 80% of a penny and perhaps six months from now, let them earn 60%, etc. I do believe that if there is a problem that it must be met head-on, in some way, to avoid unintended consquences. I must say that this is making me nervous about stock investing. Do you tink Michael Lewis's book is the reason for the recent fall in the stock market?
Thank you again for your very clear explaations.
Very informative as to evolution of HFT. But one aspect of trading not mentioned was that the specialists trading was highly regulated toward stabilizing transactions with responsibilities for maintaing fair and orderly markets whereas HFT has no such responsibilities. And where HFT accounts for 60% to 80% of volume compared to specialists in the earlier period accounting for around 20%
Shah,
Thank you for an informative and useful article. I did find one thing confusing though. In describing the 'Specialist' system you said that the specialsts 'trade on insider information' for their personal profit. An inherent built in advantage that is unfair to other investors, and illegal in regular securities transactions. Later in the article, after you describe the advent of HFT, you call the old specialist system "fair and orderly". Did I miss something?
The more I understand about the markets the more I've come to realize just how completely ignorant I am and also how much more I've learned than so many of the brokers I've had accounts with. Thanks Shah for the very best explanation of the markets today. If I'm ever made King I will appoint you as Master Ambassador for Life to the Dep't of the Treasury and in Charge of Everything.
The more I learn from Shah, the more thankful I am that we have his knowledge and support to guide us.
OK
Long term holds are taxed at 20 %
Short term holds are taxed at marginal.
Why not ultrashort (less than one minute) holds taxed at 90%?
Instantly, paid by computer, not considered in corporate income (that would be extra).
Hey, Colorado is making a bundle taxing that 'other substance'. Why not a federal tax on addictive HFT?
Hmmmmm?