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March 31, 2014 Leave a comment

High-Frequency Traders Ripping Off Investors, Michael Lewis Says
2014-03-31 04:01:00.9 GMT

By Nick Baker and Sam Mamudi
March 31 (Bloomberg) — The U.S. stock market is a rigged
game where high-frequency traders with advanced computers make
tens of billions of dollars by jumping in front of investors,
according to author Michael Lewis, who spent the past year
researching the topic for his new book “Flash Boys.”
While speed traders’ strategies, developed over the past
decade with help from exchanges, are legal, “it’s just nuts”
that they’re allowed, Lewis said during an interview televised
yesterday on CBS Corp.’s “60 Minutes.” The tactics are too
complicated for individual investors to understand, he said.
“The United States stock market, the most iconic market in
global capitalism, is rigged,” Lewis, whose books “Liar’s
Poker” and “The Big Short” highlighted Wall Street excesses,
said during the interview. The new book comes out today. “It’s
crazy that it’s legal for some people to get advance news on
prices and what investors are doing,” he said.
Everyone who owns equities is victimized by the practices,
in which the fastest traders figure out which stocks investors
plan to buy, purchase them first and then sell them back at a
higher price, said Lewis, a columnist for Bloomberg View. To
show how lucrative the tactics are, Lewis said a technology firm
spent $300 million to build a line that would shave three
milliseconds off the time it takes to communicate between New
Jersey and Chicago, then leased it out to securities companies
for $10 million each.

Industry Obsession

The author’s comments follow New York Attorney General Eric
Schneiderman’s decision to investigate privileges marketed to
professional traders that allow them to place their computers
within feet of exchanges and buy access to faster data streams.
Officials at the U.S. Securities and Exchange Commission and
Commodity Futures Trading Commission have also said market rules
may need to be examined.
Lewis is adding his voice to a debate that has obsessed the
securities industry for almost a decade while only periodically
surfacing in public via events such as the May 2010 flash crash,
in which the Dow Jones Industrial Average posted an almost 1,000
point loss. Previous books by the one-time Salomon Brothers Inc.
trader have focused attention on everything from mortgage
derivatives to baseball statistics and contributed to the outcry
over the events leading to the 2008 financial crisis.
His latest target, high-frequency trading, comprises a
diverse set of software-driven strategies that have spread from
U.S. equity markets to most developed countries as computer
power grew and regulators tried to break the grip of centralized
exchanges. While the tactics vary, they usually employ super-
fast computers to post and cancel orders at rates measured in
thousandths or even millionths of a second to capture price
discrepancies on more than 50 public and private venues that
make up the American equities market.

Dominating Volume

High-frequency traders account for about half of share
volume in the U.S., a statistic that shows their pervasiveness
and hints at the obstacles faced by proposals to rein them in.
Exchanges rely on HFTs for profits as well as liquidity, with
electronic market makers all but eliminating the old system of
human floor traders who oversaw the buying and selling of
equities. While critics such as Lewis see a Wall Street plot,
proponents say the new system is faster and cheaper.
In the U.S., the biggest high-speed traders include Virtu
Financial Inc., which filed in March to sell shares to the
public. Bats Global Markets Inc., the Lenexa, Kansas-based
equity exchange that merged with Direct Edge Holdings LLC this
year, was founded by a high-frequency trader.

Book’s Hero

“We believe Lewis’s book can have a big impact on complex
market-structure issues that have been simmering for years,”
Joe Saluzzi, co-head of equity trading at Themis Trading LLC and
a frequent critic of the status quo in markets, said before the
“60 Minutes” interview was broadcast. “Hopefully this type of
publicity will finally force regulators to take action on issues
that they’ve been sitting on for way too long.”
One of the heroes of Lewis’s book is Brad Katsuyama, who
left Royal Bank of Canada in 2012 to form a new market, IEX
Group Inc., along with other former traders from the Toronto-
based bank. David Einhorn’s Greenlight Capital Inc. hedge fund
invested in the platform, which started trading in October and
was established to minimize the influence of predatory
strategies, Goldman Sachs Group Inc. has endorsed IEX and is the
venue’s biggest broker.

Ticket Prices

IEX was established partly to address concern that
technology advances and fragmentation have made the $22 trillion
U.S. equity market too fast and opaque. The platform, a dark
pool with ambitions to officially become an exchange, imposes a
delay of 350 microseconds, or 350 millionths of a second, on
orders — enough to curb the fastest trading firms. IEX aims for
greater transparency by making its trading rules available for
public review, unlike some other electronic venues.
During his own interview with “60 Minutes,” Katsuyama
described how the stock market rips off investors. While still
at Royal Bank, he noticed that prices seemed to move against him
when he was trading.
“The best analogy I think is that your family wants to go
to a concert,” he said. “You go onto StubHub, there’s four
tickets all next to each other for 20 bucks each. You put in an
order to buy four tickets, 20 bucks each and it says, ‘You’ve
bought two tickets at 20 bucks each.’ And you go back and those
same two seats that are sitting there have now gone up to $25.”

‘My Jaw’

Katsuyama concluded that his intentions became visible on
some exchanges faster than others. The most fleet-footed traders
could take advantage of that by submitting bids and offers on
the slower markets.
Lewis said, “I spoke to dozens of investors, big
investors, famous investors who said that, ‘When Brad Katsuyama
came into my office and laid out to me how the market was
rigged, my jaw hit the floor. I mean, I knew something was
wrong. I just didn’t know what it was and no one had told us.’”
Eric Ryan, a spokesman for the New York Stock Exchange, and
Nasdaq OMX Group Inc.’s Rob Madden declined to comment on Lewis.
“We completely disagree with allegations that the U.S.
equity market is rigged,” Bats President Bill O’Brien said in
an e-mail. “While we should never stop trying to improve our
market structure, it is unfair and irresponsible to accuse
people simply because they use technology and enhance
competition. This has helped make our market the most
competitive and liquid in the world, greatly benefiting
individual investors.”

New York

New York’s Schneiderman is examining the sale of products
and services that offer faster access to data and richer
information on trades than is normally available to the public.
Wall Street banks and rapid-fire trading firms pay for these
services, providing millions of dollars in quarterly sales to
exchanges and helping ensure their markets are supplied with
standing orders to buy and sell stocks.
Bloomberg LP, the parent of Bloomberg News, provides its
clients with access to some proprietary exchange feeds.
The investigation threatens to disrupt a model that market
regulators have permitted for years as high-speed trading and
concerns about its influence have grown. Trading firms pay to
place their systems in the same data centers as the exchanges, a
practice known as co-location that lets them directly plug in
their companies’ servers and shave millionths of a second off
transactions.
High-frequency-trader Virtu publicly released its initial
public offering filing in March. The New York-based market
maker, which provides quotes in more than 10,000 securities and
contracts on more than 210 venues in 30 countries, said it had
turned a profit every day except one for five years. The company
uses IEX.

CFTC Review

Virtu disclosed in the IPO filing that the U.S. Commodity
Futures Trading Commission is looking into its trading from July
2011 to November 2013, examining its “participation in certain
incentive programs offered by exchanges or venues,” according
to the IPO filing. Virtu said it doesn’t believe it broke any
laws or CFTC rules.
Chris Concannon, Virtu’s president and chief operating
officer, declined to comment before the “60 Minutes”
broadcast, citing rules that prevent companies from speaking
while planning IPOs.
Share volume totals show the transformation that high-
frequency firms have wrought in American equity markets. While
combined trading on the NYSE and Nasdaq rarely exceeded 2
billion shares in the 1990s, today it is regularly three times
that in the U.S. About 6.05 billion shares changed hands on all
U.S. exchanges in the last session, data compiled by Bloomberg
show.

‘Not Rigged’

Not everyone says speed trading is unfair.
“While there are bad actors in every industry, the game is
not rigged in the favor of professional traders who employ HFT
to execute their strategies,” Peter Nabicht, senior adviser to
the Modern Markets Initiative trade group and former chief
technology officer at high-frequency-trading firm Allston
Trading, wrote in an e-mail.
“Rather, they work hard to compete with each other to
bring liquidity to the markets, benefiting average investors,”
he added. “Continued debate about the next evolution of market
structure is needed and welcome, provided the debate is based on
fact and resulting actions are reasoned, ensuring average
investors continue to benefit from the transparency and
efficiency enabled by inevitable technological advances.”

Encouraging Trades

The practice of selling enhanced access to brokers
accelerated as American exchanges evolved from member-owned
firms amid a flurry of regulation and computer advances in the
1990s. Among other changes, the government-mandated compression
of stock price increments to pennies from eighths and sixteenths
of a dollar, a process known as decimalization, squeezed profits
for market makers and specialists that had overseen stock
trades.
Faced with the need to maintain liquidity on electronic
platforms where profits were too fleeting for humans to capture,
exchanges encouraged computerized firms to post orders for
investors to trade against. Co-location and customized data
feeds developed alongside the hodgepodge of fees and rebates
that market operators use to keep speed traders coming back.
“Part of what you’re seeing here is people not
understanding it, because they either haven’t taken the time or
haven’t dug in,” Larry Leibowitz, the former chief operating
officer of NYSE Euronext, said in a March 25 conference call
with analysts arranged by Sandler O’Neill & Partners LP. “It’s
the responsibility of regulators to show leadership to show, ‘We
looked at these issues, and we think these are fair. These are
areas we want to improve and fine tune.’”

Old Days

Market-maker privileges have always been a hallmark of
equity trading, starting with the sale of seats on the floors of
exchanges. LaBranche & Co., created in January 1924, went public
in August 1999. In papers prepared for its IPO, LaBranche
disclosed that it regularly turned about 71 percent of sales
into profit before paying its managing directors. Earnings
before that expense climbed at least 25 percent every year from
1995 through 1999.
Results like those, as well as concern that NYSE and Nasdaq
were too powerful, helped spur reforms since 2000 such as
decimalization and a broader overhaul known as Regulation NMS
that was aimed at lowering barriers to trading. Through rules
mandating that any order for stock be routed to whoever in the
country was transmitting the best offer to buy or sell,
regulators hoped competition among a much larger pool of de
facto market makers would lower costs for investors.

Lower Fees

That happened. Buying 1,000 shares of AT&T before 1975
would have cost $800 in commissions, Charles Schwab, who founded
discount brokerage Charles Schwab Corp., told the U.S. Senate in
February 2000. That’s roughly 100 times more than the fees paid
by some retail stock-pickers today.
Federal regulators have asked for years whether new
restrictions were needed. In February 2012, Daniel Hawke, the
head of the SEC’s market-abuse unit, said the agency was
examining practices such as co-location and rebates that
exchanges pay to spur transactions. Last year, the CFTC
announced a review of speed trading and sought industry input.
SEC Commissioner Daniel Gallagher said on March 28 that
individuals are concerned that high-frequency traders detract
from fairness in the marketplace.
“The problem with high-frequency trading right now is that
there’s a perception that for the little guy, the markets aren’t
fair,” Gallagher told CNBC during an interview. “That
perception to me is a reality. It’s something we need to
address.”

 

 

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