Thank you to my friend and colleague, LN, who pointed me in directions leading to this article.
The publication of Flash Boys: Wall Street Revolt by Michael Lewis, and a recent companion article in the New York Times Magazine, blew any cover, that might have remained, off nefarious high speed trading (HST) tactics on Wall Street. HST has been controversial for years. Many traders and financial experts argue that HST firms, using proprietary technology to conduct trades in milliseconds, win commissions and guaranteed profits at the expense of average investors. Others say HST contributes to market volatility and heightens the risk of meltdowns, such as the “2010 flash crash.” But most critics and regulatory bodies have stopped short of saying these practices are illegal. Even Michael Lewis was careful to avoid that label.
Lewis, however, says the market has been “rigged” by HST firms. He uses that term, along with closely related ones, like “manipulative.” So, how different is “rigging” from “illegal?” New York state Attorney General Eric Schneiderman, whose office has jurisdiction over many Wall Street firm activities, thinks there may not be a difference. At least he’s asking about it. Schneiderman announced an investigation, which he amusingly described as “Insider Trading 2.0.” That’s a clever line, but “Insider Trading 10.40” might have been closer to the truth. We passed 2.0 about 30 years ago. Then last Friday, U.S. Attorney General Eric Holder confirmed an FBI probe into the practice. Better late than never.
Why legal authorities haven’t moved sooner to investigate HST and related practices is mystifying. Maybe it’s the same reason it took the Justice Department several years to start prosecuting the folks who brought us the 2008 financial collapse? And that effort has been tepid at best. I suppose it has something to do with waiting till the 2012 elections were over, or for the economy to gain some traction.
Come to think of it, that should have been the title of Lewis’ book — “From the Wonderful Folks Who Brought You the 2008 Economic Collapse.”
Lewis’ book and article document that high speed traders gain a lot of their advantage through a practice called “front running.” This doesn’t refer to Seattle sports fans who embrace any sport in which “one of us” is in first place. (Recall when Seattle went gaga over Thoroughbred Horse Racing when Seattle Slew came along). I digress. If I can add any value to this discussion, I will try to explain the stock brokers’ version of “front running” in terms that don’t boggle the mind.
Let me first offer a dictionary style definition. “Front running” is the practice of a stockbroker executing customers’ trade orders on stocks it also happens to own, taking advantage of this advance knowledge of pending orders, and then using that knowledge to gain an advantage in its own trades. When orders previously submitted to a broker by its customers are large enough to affect the price of a stock, the broker gains a distinct advantage. The front running broker either buys for his own account (just before filling customer buy orders that drive up the price), or sells (just before filling customer sell orders that drive down the price). All of this uses technology approaching Einsteinian limits on the speed of light. It requires that much speed to work.
If “front running” still doesn’t register, let me offer a hypothetical. Suppose a broker receives an order from a customer to buy 400,000 shares of Hoboken Tool and Dye (HTD), but before placing the order for HTD, the broker buys 20,000 shares of the same stock for his own account at $100 per share. Then, the broker places the customer’s order for 400,000 shares, driving the price up to $102 per share. This, allows the broker to (instantaneously) sell his (20,000) shares for, say, $101.75, generating a significant profit of $35,000 in just a short time. Where does this easy $35K come from? This $35,000 becomes a part of the additional cost of the customer’s purchase to support the broker’s own trading. By the way, its not written anywhere in the bible, constitution, or Adam Smith’s Wealth of Nations, that stock brokers ought to be allowed to make their own trades.
A reminder: This has nothing whatever to do with allocating capital efficiently, to the most valuable, highly demanded, and productive activities. Its a game that has nothing to do with the real economy. Why a Tea Party-er would support a candidate in a Southern primary who opposes congressional regulation of such practices, I have no idea. (Yes, I do, but that awaits another post).
As one smart Wall Street analyst put it, ” How can this not be illegal? Put the practice next to the sweeping anti-fraud language of the 1934 Securities Exchange Act. It states that “it is unlawful for any person……to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange……any manipulative or deceptive device or contrivance in contravention…..of rules and regulations [adopted]……in the public interest or for the protection of investors.” As another long time Wall Streeter notes, “it is difficult to characterize the chiseling of unsuspecting investors through high speed computer algorithms as anything other than chronic manipulative theft at millisecond intervals.
The fact that a high-speed trading firm called Virtu Financial recently disclosed that it lost money trading only one day in the past five years, suggests certain traders enjoy considerable—and maybe illegal—advantages. You think? Check out the Investment Watch analysis.
I’ve posted earlier about HST, pointing out that it accounted for anywhere between 50 to 70 percent of trades in U.S. exchanges…..but flew in the face of classic capitalism. Lewis agrees with that position. “From the point of view of the most sophisticated traders,” Lewis says in his NYT article, “the stock market wasn’t a mechanism for channeling capital to productive enterprise but a puzzle to be solved.” “Investing shouldn’t be about gaming a system,” he says, “It should be about something else.”