Need for speed: The lowdown on high-frequency trading

Michael Lewis' latest book 'Flash Boys' sheds light on the perverse financial incentives created by high-frequency trading, with regulators pledging to investigate the practice.

The idea that the US stockmarket is rigged to hurt the average mum and dad investor sounds like a ripper idea for a movie script, doesn’t it? That could soon be the case following the release of Michael Lewis’ new book Flash Boys: A Wall Street Revolt

The author of Moneyball and The Blind Side -- both stories that were turned into Oscar-nominated movies -- takes on high-frequency traders in his new book, which was released to much noise this week in the US.

It is a juicy if not complicated area to explore. Lewis does it well by using a character-driven narrative to explain complex financial instruments and hammer home a simple point -- that the little guy is being screwed by more professional share investors.

High-frequency trading basically relies on super-fast computers and complex algorithms to allow traders to buy shares quicker than anyone else.

When an institutional investor, say a bank or a hedge fund, wants to execute a trade, they place an order for a stock at a certain price and then send that order to various stock exchanges to be filled. 

Companies that are equipped to do high-frequency trades receive that order and can tell when, for instance, a whole heap of Facebook shares are about to be purchased.

So in the split second before that trade is filled they can start buying the stock and force whoever made the original order to purchase at a higher price. The practice is known in the game as “front-running” and is entirely legal.

In fact, it is not only legal but is encouraged by stockmarkets like the New York Stock Exchange, Nasdaq and Bats, an electronic exchange that was a pioneer in high-frequency trading.

These platforms have created pricing systems whereby higher rates are charged for faster speeds. Basically the more you pay, the faster you trade. That means there is a perverse financial incentive to have an uneven playing field.

Blood boiled on Wall Street following Lewis’ appearance on US 60 Minutes on Sunday ahead of Monday’s release of Flash Boys.

Those supporters of high-frequency trading argue that the more people you have in a market, the better the prices. Liquidity is added, which makes it easier and cheaper to trade.

Others believe it allows for companies within the same industry to be more accurately priced.

For example, if bad weather hits raw materials like the sugar that goes into making things like soft drinks, then a stock like Coca-Cola would see a fall in its share price because its product will be more expensive to make. 

However, less high-profile soft drink makers might see that impact flush through their share price over a number of days. Traders say this is an example of how the market can get out of sync with itself.

Then there are those that believe high-frequency trading isn’t really an issue because it is rarely the average mum and dad investor who is losing out, but rather big institutions like superannuation funds. That seems to me to be an obtuse argument -- except when you consider that those same mum and dad investors are likely to be the clients of those big superannuation funds.

Just because the big institutions are losing more money from high-frequency trading than average investors does not make the uneven playing field any more even.

Goldman Sachs, one of the first high-frequency traders, has come out in favour of stronger rules that would make the system fairer.

Eric Hunsader, the man who has long been called the nemesis of high-frequency traders and who features in Lewis' book, argues that liquidity is actually removed from the market as the 'flash boys' push prices up for other buyers wanting the same stock.

Wall Street stockbrokers Rosenblatt Securities estimate the entire speed-trading industry made about $US1 billion last year compared with 2009 when traders were pulling in close to $US5bn. So there is some truth when critics say it isn’t as much of a problem as it was before the financial crisis.

Less than 24 hours after Lewis’ appearance on 60 Minutes to promote his book, the FBI confessed that it had been investigating high-frequency trading for about a year.

The US Securities Exchange Commission, which has been criticised for being late to the party, has also pledged to look at the practice.

SEC commissioner Daniel Gallagher summed up why high-frequency trading needs to be investigated.

“The problem with high-frequency trading right now is that there’s a perception that for the little guy, the markets aren’t fair,” he told CNBC. “That perception to me is a reality. It’s something we need to address.”

Healthy markets thrive on confidence and that needs to be felt right through the chain in order to produce a fully-functioning market. Incentives that allow a privileged few to jump the queue and ride in the fast lane will only rattle already shaky confidence and tepid participation, which threaten to bring the sharemarket to a screeching halt.

Mathew Murphy is a Walkley Award-winning journalist based in New York.

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