Michael Lewis Says Flash Traders Rig the Market

His new book, Flash Boys, describes an electronic trading system that advantages a rarified few. 

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By Bob Pisani,
CNBC
March 31, 2014

Michael Lewis gave an interview to "60 Minutes" ahead of the publication of his book, Flash Boys. He alleges that the stock market is "rigged" by a cabal of high frequency traders, stock exchanges, and Wall Street firms.

He alleges that a lone fellow, a trader named Brad Katsuyama, figured this out and formed a new exchanged, IEX, to combat abuses perpetrated against the investing community. He alleges that high frequency traders are able to front run orders, which means they are able to buy in front of you and sell them back to you when you want to buy.

The problem, he says, is in the plumbing of the stock market. In the most interesting part of the interview, they showed a moving diagram of an order that leaves downtown New York and goes to the BATS exchange servers in Weehawken, N.J. Because the exchanges all connect to each other, the order then goes to the servers of the New York Stock Exchange, which is a few miles away in Mahwah, N.J.

Related:  On Wall Street, 'Tick Size' Does Matter

According to Lewis, that's where the alleged front running occurs: in this example, they imply that the existence of high-priced fiber optic lines connecting the exchanges allow traders to get from Weehawken to Mahwah faster than the "public lines" that are provided to those who don't pay the higher fees for the faster lines, allowing these traders to profit from the knowledge of the prices in the slower feeds.

Should they be allowed to do this? When pressed, Mr. Lewis reluctantly admitted that this was perfectly legal, and so it wasn't front running, which was illegal. He then took to calling it "legal front running."

IEX has proposed that outgoing messages arrive at all exchanges at the same time and incoming messages go through a "speed box" that slows them down, so everything arrives everywhere at the same time. This is a simple solution to the problem. 

And that was about it. High-speed traders have fiber-optic lines that get information to places faster, and I met a guy who has a solution to this problem. This is news? 

Proprietary Feeds
The odd thing about the interview is that they did not bring up the hottest topic around high-speed trading: that high-speed traders have access to a "proprietary feed" that allows them to have a trading advantage over those who rely on the "public feed."

There is indeed a "proprietary feed" which has been provided to anyone willing to pay for it, with the blessing of the SEC, for many years.

The core argument is that those who access this proprietary feed can calculate the most current bids and offers (known as the National Best Bid and Offer, or NBBO) quicker than those who get the public feed (known as the Securities Information Processor, or SIP). That can indeed provide a trading advantage.

Related: Why Nasdaq's Flash Freeze Matters - and Doesn't

Why do these proprietary feeds exist? Because they provide much more detailed trading activity than the public feed. This information is valuable to those who are the most active traders (proprietary traders, institutional traders, certain hedge fund traders) as it gives them a deeper look at the size and depth of the market, and exchanges charge accordingly for the information.

Let me give you an example of what the proprietary feed does. Suppose I am an institutional trader and want to buy 10,000 shares of Apple stock…the bid is $535.00, the ask is $535.01. 

The public feed – the SIP – will only show the last price, and the bid and ask price, what is called "top of the book." The proprietary feed will tell me how deep the book is, and at what price levels.

So it will show me, for example, that there are 1,000 shares to buy immediately at $530.01, then 2,000 at $530.02, then 3,000 at $530.03, then 4,000 shares at $530.04. 

Obviously, this is dynamic and the prices change all the time, but you get the point: the proprietary feed provides much more information.

Related: Why Companies Are Just Sitting on Mountains of Cash

It's alleged that these public feeds allow traders to react more quickly because the public feed are sent to a central point for processing before they are sent out, whereas private feeds are not, and that this gives high-speed traders a small advantage, literally measured in milliseconds (thousandths of a second). There may be something to this, but it's not clear how big a deal it is.

There was a widely discussed academic paper published in January of this year that looked carefully at this. The authors studied Apple's stock on several days in 2012 and found a difference of 1.5 milliseconds between the proprietary feed and the public feed. That is enough time for a trader with fast enough equipment to trade against someone with access to only the slower feed.

Is there a significant price dislocation? The authors conclude that the median price dislocation is one cent, and the mean was 3.4 cents.

A one-cent difference is not trivial, but it's not a huge amount either. But here's the kicker: the dislocations last only several milliseconds. "Therefore, while dislocations are costly and frequent, their impact on infrequently trading investors can be quite small as prices are dislocated less than one percent of the time," the authors conclude.

Obviously, the costs for those trading more frequently will be higher, since their volume will be greater. But even here, the study estimates that fast traders might in total capture a profit of $32,510 in a single day of trading in Apple. This is not a trivial amount but it is hardly an ocean of profits, given Apple's huge volume and high price.

The study also notes that dislocations are higher on days with higher volatility. This is no surprise, since high volatility days are associated with wider spreads.

There is another, closely connected argument made against high speed traders as well. That they can use this information to try to figure out what kind of trading strategies are being used at any one time and adjust their trading accordingly. This can get close to being "abusive and manipulative" market practices as defined by the SEC, but it is hard to prove.

I've said many times that I would support looking into charging some kind of excess message traffic for those who send in huge orders to buy and sell stock that are rapidly cancelled. Such practices, if done on a large enough scale, can certainly have the smell of abusive practices, but the devil is in the details.

Bottom Line
What's the bottom line? If you are a long-term buyer, under some circumstances – particularly during times of high volatility – high-speed traders are indeed trying to scalp a penny on your trade.

Would I like to see fewer of these price dislocations? I sure would. Do I think this is some outrageous act of highway robbery?  Well, I'm not so sure. What should be done about high-frequency trading? Let's start with two basic principles.

1) As a general rule, information should be available to all participants at the same time. If that involves instituting some kind of "speed bump" as the IEX currently employs, that is worth looking at, but only in the way described at the IEX. If there is simply a rule that says, "all incoming trades have to wait one second before they execute," than they guy with the fastest computer will still have an advantage, it will just be one second later.

2) Regulators should have the tools to detect abuse of the system. I'm afraid they don't have it now, but they are making progress. The SEC recently unveiled a new system, dubbed MIDAS, designed partly to look for manipulative behavior.

The SEC has put out bids for a deeper and more sophisticated tool, called the Consolidated Audit Trail, that would record every quote, every trade, every customer and would give the regulators a much clearer understanding of what is going on. 

That will not come before 2015, but it will be a welcome development.

One final point about the 60 Minutes story: for a story that made the bold claim that the U.S. stock market was "rigged" and named as co-conspirators the New York Stock Exchange, the NASDAQ, all the brokerage firms on Wall Street, and a bunch of high frequency traders, you know what the story lacked?

Not a single one of these co-conspirators were in the story. And, apparently, they were not even contacted. We didn't hear a single "we contacted the NASDAQ, and they refused to comment."

Not a single "we caught up with JPMorgan CEO Jamie Dimon and asked him about these activities, and he ran away." Nothing. Strange, no?

This article originally appeared in CNBC

Read more at CNBC:
Michael Lewis' 'Flash Boys' and high-speed trading
Speed trading firms get an edge over individual traders
SEC official: What's hurting the 'little guy'