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The High-Tech Wall Street Rip-Off Setting the Media on Fire

Dangerous and predatory high-frequency trading is bad for markets, bad for regular people and bad for society.
 
 
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A brand-new book by Michael Lewis, author of Liar’s Poker and Moneyball, has set the media on fire. In Flash Boys: A Wall Street Revolt, Lewis argues that not only do the liars on Wall Street play poker, but the poker game itself is completely rigged against the little guy.

You, my friend, are the little guy. So am I. And so is everyone else who does not have access to a supercomputer.

Lewis contends that the U.S. stock market — you know, that famous system which impacts how much money is in your 401(k) — is rigged in favor of high-speed electronic trading firms, which use their advantages to rip off investors to the tunes of billions of dollars a year. These firms engage in a widespread practice known as high-frequency trading (HFT). Let's explore why this is very bad for you and me. (Be sure to check out Lewis' 60 Minutes interview, which also features young Brad Katsuyama, the Canadian trader who helped suss out the problem.)

What the Heck Is High-Frequency Trading?

High-frequency trading is trading on steroids. It has exploded onto Wall Street over the last decade, now accounting for 60 percent of the equity action. The firms that do it typically use super-fast computers to post and cancel orders at rates measured in thousandths or even millionths of a second to capture price discrepancies — and that’s how the profits roll in. The practice attracted the attention of regulators after the so-called "flash crash" in May 2010, when the Dow Jones Industrial Average briefly lost almost 1,000 points and scared the crap out of everyone.

Right now, both the Federal Bureau of Investigation and the NY State Attorney General, Eric Schneiderman, have started investigating whether U.S. stock exchanges and alternative trading venues provide improper advantages to high-frequency traders.

Financial “Innovation” Is Very Expensive for Main Street

Wall Street loves to brag about its innovative capacity. But somehow, that innovation often points to one outcome: Main Street gets ripped off.

By simply monopolizing a huge chunk of the stock market’s volume, big firms that engage in high-frequency trading generate very nice profits for themselves. But why should they be allowed to have this advantage? Capturing minute price disparities hardly seems like the reason we set up capital markets in the first place. In the old days, these markets existed for the purpose of providing capital to Main Street to help the latter grow and create more jobs and prosperity. But not all innovation in finance is useful, not all trading plays a useful social role, and a bigger and faster financial system is not necessarily a better one.

High-frequency trading undermines our financial system in a number of ways. For one thing, it’s bad for market transparency, because institutional investors tend to divert some of their trades to what folks in the finance community call “dark pools.” In these privately run stock markets, traders conduct business anonymously and they escape proper regulatory oversight.

A lot of high-frequency trading is done by small proprietary trading firms, which are subject to less oversight than brand name financial institutions. That provides even greater scope to rip off retail investors. Then there’s the unethical practice of “front-running,” which happens when traders are able to purchase orders in front of you and then sell them back to you when you want to buy. The sheer speed of these high frequency trades makes front-running much harder to prove. Finally, high-frequency trading breaks down trust in markets. Thanks to recent high-frequency-trading-related debacles like the flash crash and Kraft’s first trading day at NASDAQ, when its initial trades had to be cancelled, retail investors are wary—and rightly so.