Tuesday, April 8, 2014

Flash Trading - Jumping Ahead

Michael Lewis published his latest book titled “A Wall Street Revolt – Flash Boys” on March 31, 2014. Lewis says that stock market envisioned as a mechanism of channeling capital to seekers of capital has morphed into a puzzle to be solved. The book alleges that high frequency traders (HTFs) armed with an arsenal of computers and other gadgets try to siphon away miniscule gains from the common investor. The din on HTFs has grown louder and louder as FBI is launching an investigation on HTFs alleging insider trading. The SEC is also engaged in investigations of their own. The Commodities Futures Trading Commission and New York Attorney General are investigating whether the ties between the HTFs and the exchanges are making them privy to some preferential information and treatment.

This hubbub about this supposedly nefarious activity makes us believe that HTFs are illegal. However, quite to the contrary HTFs are legal and are perhaps the unintended consequence of Regulation NMS conceived by the SEC in 2005 and implemented in 2007. Reg NMS created a digital inter-linked architecture of the US stock markets to better compete with other financial centers. Reg NMS mandated that any order has to be filled at the best price. Before Reg NMS brokers aimed to send an order to buy or sell a security to an exchange where they believed the order had a high probability of executing at a fair price. Reg NMS changed the focus to execute at the best possible price hence a broker’s computer has to now scan every possible exchange on which prices are quoted. A stock exchange’s profitability depends on the volume of transaction conducted on its trading platforms. Therefore, a heavy flow of orders benefits the exchange. To obtain large volumes of orders the exchange offers incentives to trading firms who trade large volumes and at the same time they also charge investors who want to accept the prices the market maker’s quote. The incentives include benefits such as discount on fees to execute trades and priority to data feeds. The HTFs armed with these data feeds use computer algorithm to place huge volume of trades in an effort to parse out any minor changes in demand and supply. In such a virtual world speed is key and even the tiniest edge would ensure a sure profit.

Reg NMS also created private exchanges and ‘dark pools’. Following Reg NMS it became valuable for a virtual trading platform to become a full-fledged exchange because the trade will be executed if it displays the best price. The ‘dark pools’ and private electronic trading venues do not publicly display the bid-ask prices. To escape the fees charged by exchanges brokers have incentives to direct trades to these dark pools, which could be cheaper and may have better prices.

Because orders are now bounced from pillar-to-post to find the best price it is easier for these sophisticated algorithms to detect the size and price and in due course get ahead and the mark up the price for the ultimate trader. It seems that camp HTF dissenters is growing quickly but supporters of HTFs argue that algorithmic trading helps the stock market in achieving better and lower prices. An efficient price discovery mechanism is essential to a robust market. However, you cannot find fault with the common man who is annoyed because somebody jumped in front of the queue.  

1. “A Suspect Emerges in Stock-Trade Hiccups: Regulation NMS”, Jacob Bunge, WSJ, Jan 27, 2014
2. “FBI Investigates High-Speed Trading”, Scott Patterson and Michael Rothfeld, WSJ, March 31, 3014.
3. “For Superfast Stock Traders, a Way to Jump Ahead in Line”, Scott Patterson and Jenny Strasburg, WSJ, Sep 19, 2012
4. “SEC Investigations into High-Frequency Trading Underway”, Andrew Ackerman, WSJ, April 1, 2014
5. “High Frequency Trading Firms Face New U.S. Scrutiny”, Scott Patterson and Jenny Strasburg, WSJ, March 18, 2014.
6. “Michael Lewis has shown how tech nerds rigged the stock markets. But who will guard the geeks?” John Naughton, The Guardian, April 5, 2014.

Dr. Subramanian “Subbu” Rama Iyer is an assistant professor of Finance at UNM Anderson School of Management. Click here to contact Dr. Iyer.

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