Since everyone else is talking about it, I might as well throw my two cents into the game. Recently 60 Minutes did a classic hatchet job on high frequency trading (like it was something new). CBS reported on the findings of a new book by Michael Lewis, entitled “Flash Boys.” In the report we learn that Brad Katsuyama, a manager in charge of the trade desk at the Royal Bank of Canada, discovered that any time one of his big customers mutual funds, pension funds, major hedge funds, and the like started to make a major move into a particular stock, the price jumped more that could be predicted by normal market forces. I sure the same thing could be said about price drops when massive sales orders were executed by the same large investment entities. With the help of a technical genius, Katsuyama discovered exactly how the current crop of high frequency trading programs were jumping in front of the market, essentially skimming a fraction of a cent per share to a few cents per share in profits by anticipating the jump in price caused by a major order by only a few milliseconds.
This is not illegal and it is not new. The first time I became aware of what was then called “program trading” occurred in the aftermath of Black Monday, October 19, 1987 when the Dow dropped by 22.6% in a single day. In 1987 automated computer trading had reached a point where enough computers were caught in the same feedback loop that they managed to collapse the market. Since then the major markets have installed “circuit breakers” that shut the market down when threatened by this kind of automated trading.
Today trades untouched by human minds or hands account for roughly ½ of all market activity. It is reported that one company engaged in these activities, holds a position in a stock for an average of 11 seconds! What started as an attempt to automatically mimic the actions of human traders using the principles of technical analysis, has morphed into a market unto itself operating in the “hyper space” of trades executed in the realm of milliseconds.
The introduction of computers into the stock exchanges has revolutionized the way the “little guy” can play the game. Placing a trade once cost in the neighborhood of $150. Now if you are paying more than $10 a trade you are paying too much. The Internet has made it faster and safer to execute a buy or sell order than at anytime in history. Michael Lewis and Brad Katsuyama are incensed that what benefits you also benefits a new breed of players backed by hundreds of millions of dollars in high speed communication networks and the latest generation of supercomputers.
Like King Kong back in the 1930s the largest customers of the Royal Bank of Canada were happily stomping around world capitals without any competition. Then this giant radioactive lizard came out of the sea and spoiled their little party. Katsuyama, an enterprising imaginative capitalist, proposed a market solution that didn’t require any intervention by the Security and Exchange Commission. Backed by players like Goldman Sachs, once famously termed a “great vampire squid wrapped around the face of humanity,” in a Rolling Stone Magazine article, Katsuyama has opened a private stock exchange, the IEX Group, for high rollers that uses technology to cut Godzilla, the high frequency traders, out of the loop.
This is not a new idea. There is a name for this kind of private club, dark pools. In fact in one of the two interviews I watched on this subject, Katsuyama actually uses that term. Back in 2009 I wrote, “Dark Pools: Major trading houses set up off line electronic trading venues for their largest and best customers. Within these secretive private exchanges, high rollers can move huge quantities of shares away from public view. They affect the value of your stocks but you will never know what happened in private until it is way too late to do anything about it. If the dark pools become large enough, they will also affect the number of shares available on the open market creating a double price structure. Guess which price is the real price. It is currently estimated about 7% of all trades take place in dark pools.”
To tell the truth I am more worried by dark pools than I am by high frequency trading.
It is reported that the New York Attorney General, Eric Schneiderman and the FBI are actively investigating the activities of high frequency trading operations. In addition the Security and Exchange Commission are revisiting the current trading rules to determine if they still make sense given the improvements in technology. I have nothing against smart people learning how to work the rules to their advantage. That is why I pay a CPA to prepare my tax returns. That is why I worked with a lawyer and an estate planner when I prepared my will. However, I hope the people making and enforcing the rules aren’t too far behind the curve. Parasites, like high frequency traders, don’t increase the wealth of a nation. They merely divert a small portion of it into their pockets at the expense of the high rollers. Unfortunately, if you own shares in a major mutual fund or will someday benefit from a pension you are one of those high rollers.
When you invest in the market always remember that the high rollers play by a different set of rules. That is as it should be. If you are private investor who can bring $50,000 to the table, you will get a better deal from Vanguard (that most ethical of all mutual fund families) than you will get with their $3,000 house minimum. If you have over $250,000 in an investment account at Schwab, they will assign a broker to make sure you are happy and sleeping well at night.
At the end of the movie, after completely trashing Japan, Godzilla disappears back into the ocean that spawned him and King Kong begins the long swim back to Skull Island. Don’t worry. They will be back for the squeal. This time the monsters won’t be actors in cheesy rubber suits. They will be portrayed in 3D by the latest in high tech computer graphics.
Now. Please. Let’s be careful out there!
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