Our regular readers know that Michael Lewis is one of my favorite authors. His books such as “The Blind Side”, “Moneyball”, “Liar’s Poker”, and others are great reads. He focuses on a significant development in an industry, finds compelling characters and tells a great story. He’s done it again with “Flash Boys”, which focuses on high-frequency trading (“HFT”) and how we investors are being scammed by the HFT firms Lewis dubs as “Scalpers, Inc.”
Michael Lewis started his career with Salomon Brothers in the mid ’80’s as a bond salesman. Back then, trading was done by humans; think of “thick-necked guys in color-coded jackets standing in trading pits hollering at each other.” The Black Monday market crash of October 19, 1987 changed all of that. It set in motion a process where today all trading is being done by computers, not humans. HFT is a type of rapid algorithmic trading. The faster the better.
After the collapse of Lehman Brothers in 2008, exchanges such as the NYSE started a program designed to add competition and liquidity to the market. They pay HFT companies a rebate of $.0015 for doing this. But the real money for the HFT firms is matching orders. Acting as intermediaries to buy and sell securities, they are in a unique position to do this in a way that can provide them a nice profit.
Discount brokerages such as E*Trade, TD Ameritrade and Charles Schwab are paid by the HFT wholesale companies for their order flow. The HFT firms capture tiny profits on many of the trades, without even using the exchanges. It’s big business. It’s estimated that HFT companies generated $5 billion of revenue in 2009. For 2013, about $1 billion.
It’s all legal. The speediest HFTs have great advantages. They can co-locate their equipment inside the exchanges, their orders go to the front of the queue, and they can pay to get early peeks on news releases. This information allows them to front-run orders- knowing how someone is going to trade and profiting from getting in front of that trade. The result is that some HFT traders claim to be profitable on over 99% of their trading days. Making pennies on transactions, but millions of them, with virtually no risk- ergo, “Scalpers, Inc.”
Charles Schwab & Co. declared last week that “HFT is a growing cancer that needs to be addressed.” Schwab believes HFT has “run amok and is corrupting our capital market system by creating an unleveled playing field for individual investors and driving the wrong incentives for our commodity and equities exchanges.” Schwab continues, “HFT isn’t providing more efficient, liquid markets; it’s a technological arms race designed to pick the pockets of legitimate market participants.”
Michael Lewis isn’t the first or only person to focus on HFT. Two years ago, Scott Patterson of the WSJ wrote a book titled, “Dark Pools: The Rise of Machine Traders and the Rigging of the U.S. Stock Market”, which also exposed the scam. What’s great about Michael Lewis is that he really has brought major attention to the problem. His appearances on “60 Minutes” and other shows have become ubiquitous over the last two weeks. The F.B.I., the Justice Department and NY’s Attorney General, and the SEC are now investigating HFT.
The dollar impact on a typical investor’s portfolio is tiny- probably less than $50 per year on a $1 million portfolio. The real problem is bigger than that.
HFT undermines integrity and causes the market to lose credibility and investors to lose trust. This hurts our economy and our country. I’m glad that Michael Lewis has brought attention to HFT. There are alternatives. There is even a new exchange that has been created by Lewis’s hero in the book, Brad Katsuyama. The focus of IEX Group Inc. is all about fairness and transparency. Its website describes IEX as “A Market That Works for Investors.” What a novel idea!