High-Frequency Trading and You

April 11, 2014
Jeff Brown, MD

Stock trades are now made on banks of faceless servers in less than heartbeat. So the markets have thus become even more equitable and fair, right? Enter the unfair advantage of high-frequency traders.

Most people know by now that the image of the “pit” where stockbrokers wave pieces of paper and holler at each other to make trades is a relic of the past. Stock trades are now made on banks of faceless servers, many of them in New Jersey, oddly enough. It is all electronic and fast with trades made in less than heartbeat.

So the markets have thus become even more equitable and fair, right?

Wrong, says Michael Lewis in his new book, The Flash Boys, which is shaking up Wall Street and the otherwise action-less halls of Congress. You might remember Lewis as the author of The Big Short, about the market crash of 2008, and Moneyball, about the statistical re-think of Major League Baseball.

Lewis has researched the hidden world of automatic computer algorithms in stock trades that now accounts for at least half of all trades every day. To achieve this mighty task, there are some 2,000 math and physics PhDs on Wall Street who have constructed these arcane programs to gain vital milliseconds on the rest of the market.

And most of the fast-trade firms are privately held, so they do not have to report to the public and so they are only loosely regulated. Even the lowest estimates of their annual net are in the billions, raked in, amazingly, a few pennies at a time on a vast volume of trades.

The knock on them is that, via proprietary fiber optic cables from Wall Street to the above mentioned New Jersey sites, these firms have a tiny speed edge on the rest of the market so they can jump the line, buy stocks ahead of wired trades, and then sell them to regular buyers at a tiny increase in price. All in milliseconds. It is, so far, legal and guaranteed profitable.

There is the rub and the reason why even the Justice Department is looking into this situation now. These few private firms with the proprietary cables and software functionally have what amounts to receiving insider information a millisecond before the general public, and they have the means to act on that knowledge thousands of times per day.

Note that the victims of this comfortable arrangement are not just the little yous and mes of the world—the IRA and 401(k) warriors—but, more ominously, the big banks and the large, non-participating private equity and hedge funds. And they don’t like knowing that billions are leaking out this “hole in their pockets” to these interlopers.

This has been going on for some 5-plus years (no one is saying how long), but has just come to light. Bart Katsuyama, an astute trader at a Canadian bank, noticed some tiny discrepancies in his buy and sell pricing and looked into this murky world. As a result, he left his secure multi-million dollar job and opened up his own exchange, against all odds and all advice, with a built-in braking device on high-frequency trading.

What makes the story so interesting is that many of the Big Boys have heard him and switched their business to his more level playing field. A few days ago, Charles Schwab announced that all of its business would be transferred to the new IEX stock exchange, following Goldman Sachs and other players.

Lewis is a good, easy-to-understand writer, which really helps in this arcane field. And his book has struck a nerve, which will reverberate through the headlines in the coming months.

Please note that this situation affects each of us, directly or indirectly, and is not just a matter for “them.”