Posted 2 years ago on Dec. 29, 2014, 11:58 a.m. EST by TechJunkie
from Miami Beach, FL
This content is user submitted and not an official statement
Computer programs are prowling the stock markets (there are many different stock markets now) waiting for you to make a trade. The instant that you put in an order to buy stock, the computer programs rush to get ahead of your order and buy the stock before you. Then they sell it to you at a profit. That's called "high-frequency trading", or HFT.
How big of an issue is this? Sal Arnuk and Joseph Saluzzi wrote in the book Broken Markets:
Although there are few HFTs relative to the number of investors in the marketplace, the following is generally estimated in the industry:
• HFTs account for 50– 75% of the volume traded on the exchanges each day and a substantial portion of the stock exchanges’ profits. • While smaller HFTs churn hundreds of millions of shares per day, a few of the larger HFTs each account for more than 10% of any given day’s trading volume. • HFTs earn anywhere from $ 8 billion to as much as $ 21 billion a year that comes at the expense of long-term investors— you and the institutional investors that manage money on behalf of you.
Arnuk, Sal; Saluzzi, Joseph (2012-05-22). Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street Are Destroying Investor Confidence and Your Portfolio (Kindle Locations 263-269). Pearson Education. Kindle Edition.
If HFTs account for over 50% of all trades, then that means that EVERY TRADE has a computer program inserted as a middleman. Every single time that you attempt to invest money in the stock market for your retirement, you pay a tax to a shadowy group of technologists who successfully lobbied the SEC to fundamentally change the structure of the stock market in 2007.
Seems like something that OWS would be upset about.
The U.S. stock market was now a class system, rooted in speed, of haves and have-nots. The haves paid for nanoseconds; the have-nots had no idea that a nanosecond had value.
How could this happen?
The Reg NMS system that decentralized the stock market into many different stock exchanges was a regulatory system that was designed to make the stock market more fair, after allegations of front-running in 1987. Reg NMS requires brokers to find the best market prices for the investors that they represent. It was designed to prevent one kind of front-running, but it enabled an entirely new kind of front-running.
Up till then the various brokers who handled investors’ stock market orders had been held to the loose standard of “best execution.” What that meant in practice was subject to interpretation. If you wanted to buy 10,000 shares of Microsoft at $ 30 a share, and the broker went into the market and saw that there were only 100 shares offered at $ 30, he might choose not to buy those hundred shares and wait until more sellers turned up. He had the discretion not to spook the market, and to play your hand on your behalf as smartly as he could. After the brokers abused the trust implicit in that discretion once too often, the government took the discretion away. Reg NMS replaced the loose notion of best execution with the tight legal one of “best price.” To define best price, Reg NMS relied on the concept of the National Best Bid and Offer, known as the NBBO. If an investor wished to buy 10,000 shares of Microsoft, and 100 shares were offered on the BATS exchange at $ 30 a share, while the full 10,000 listed on the other twelve exchanges were offered at $ 30.01, his broker was required to purchase the 100 shares on Bats at $ 30 before moving on to the other exchanges. “It mandated routing to more exchanges than you might otherwise have to go to,” said Schwall. “And so it created more opportunities for people to front-run you.” The regulation also made it far easier for high-frequency traders to predict where brokers would send their customers’ orders , as they must send them first to the exchange that offered the best market price.
That would have been fine but for the manner in which the best market price was calculated. The new law required a mechanism for taking the measure of the entire market— for creating the National Best Bid and Offer— by compiling all the bids and offers for all U.S. stocks in one place. That place, inside some computer, was called the Securities Information Processor, which, because there is no such thing on Wall Street as too many acronyms, became known as the SIP. The thirteen stock markets piped their prices into the SIP, and the SIP calculated the NBBO. The SIP was the picture of the U.S. stock market most investors saw.
Like a lot of regulations, Reg NMS was well-meaning and sensible. If everyone on Wall Street abided by the rule’s spirit, the rule would have established a new fairness in the U.S. stock market. The rule, however, contained a loophole: It failed to specify the speed of the SIP. To gather and organize the stock prices from all the exchanges took milliseconds. It took milliseconds more to disseminate those calculations. The technology used to perform these calculations was old and slow, and the exchanges apparently had little interest in improving it. There was no rule against high-frequency traders setting up computers inside the exchanges and building their own, much faster, better cared for version of the SIP. That’s exactly what they’d done, so well that there were times when the gap between the high-frequency traders’ view of the market and that of ordinary investors could be twenty-five milliseconds, or twice the time it now took to travel from New York to Chicago and back again.
Reg NMS was intended to create equality of opportunity in the U.S. stock market. Instead it institutionalized a more pernicious inequality. A small class of insiders with the resources to create speed were now allowed to preview the market and trade on what they had seen.
Lewis, Michael (2014-03-31). Flash Boys: A Wall Street Revolt (pp. 96-99). W. W. Norton & Company. Kindle Edition.
That's just one example. The problem is the overall pattern:
When [Schwall] saw that Reg NMS had been created to correct for the market manipulations of the old NYSE specialists, he wanted to know: How had that corruption come about? He began another search. He discovered that the New York Stock Exchange specialists had been exploiting a loophole in some earlier regulation— which of course just led Schwall to ask: What event had led the SEC to create that regulation? Many hours later he’d clawed his way back to the 1987 stock market crash, which, as it turned out, gave rise to the first, albeit crude, form of high-frequency trading. During the 1987 crash, Wall Street brokers, to avoid having to buy stock, had stopped answering their phones, and small investors were unable to enter their orders into the market. In response, the government regulators had mandated the creation of an electronic Small Order Execution System so that the little guy’s order could be sent into the market with the press of a key on a computer keyboard, without a stockbroker first taking it from him on the phone. Because a computer was able to transmit trades must faster than humans, the system was soon gamed by smart traders, for purposes having nothing to do with the little guy. † At which point Schwall naturally asked: From whence came the regulation that had made brokers feel comfortable not answering their phones in the midst of the 1987 stock market crash?
As it turns out, when you Google “front-running” and “Wall Street” and “scandal,” and you are hell-bent on following the search to its conclusion, the journey cannot be finished in an evening. At five o’clock Monday morning Schwall finally went back inside his house. He slept for two hours, then rose and called Brad to tell him he wasn’t coming to work. Then he set off for a Staten Island branch of the New York Public Library. “There was quite a bit of vengeance on my mind,” he said. As a high school junior Schwall had been New York City’s wrestling champion in the 119-pound division. “He’s the nicest guy in the world most of the time,” said Brad. “But then sometimes he’s not.” A streak of anger ran through him, and exactly where it came from Schwall could not say, but he knew perfectly well what triggered it: injustice. “If I can fix something and fuck these people who are fucking the rest of this country , I’m going to do it,” he said. The trigger for his most recent burst of feeling was Thor, but if you had asked him on Wednesday morning why he was still digging around the Staten Island library instead of going to work , Schwall wouldn’t have thought to mention Thor. Instead he would have said, “I am trying to understand the origins of every form of front-running in the history of the United States.”
Several days later he’d worked his way back to the late 1800s. The entire history of Wall Street was the story of scandals, it now seemed to him, linked together tail to trunk like circus elephants. Every systemic market injustice arose from some loophole in a regulation created to correct some prior injustice. “No matter what the regulators did, some other intermediary found a way to react, so there would be another form of front-running,” he said. When he was done in the Staten Island library he returned to work , as if there was nothing unusual at all about the product manager having turned himself into a private eye. He’d learned several important things, he told his colleagues. First, there was nothing new about the behavior they were at war with: The U.S. financial markets had always been either corrupt or about to be corrupted. Second, there was zero chance that the problem would be solved by financial regulators; or, rather, the regulators might solve the narrow problem of front-running in the stock market by high-frequency traders, but whatever they did to solve the problem would create yet another opportunity for financial intermediaries to make money at the expense of investors.
Lewis, Michael (2014-03-31). Flash Boys: A Wall Street Revolt (pp. 99-102). W. W. Norton & Company. Kindle Edition.
[Updated with background from this post]