Is the Stock Market Really Rigged?

shoebox optic fiber

20 Dec Is the Stock Market Really Rigged?

In April 2014, best selling author Michael Lewis published FlashBoys, a narrative non-fiction depicting the rise of High Frequency Trading (HFT) and how financial institutions; brokerages and stock exchanges are involved in the HFT ecosystem.

As recent as the early 2000s, 85% of all stock trades in the USA happened on either one of two exchanges – NYSE or NASDAQ. The exchanges were exclusive; a stock that is traded on NYSE does not trade on NASDAQ.

In an attempt to promote freer markets, the Securities Exchange Commission (SEC) allowed more exchanges to spout. By 2008, there were 13 exchanges in the US. An investor could buy or sell a stock on almost any exchange of his choice.

More exchanges would normally mean more efficient markets, but as Brad Katsuyama, the protagonist of FlashBoys discovered, that was not the case.

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Katsuyama is a Canadian trader who arrived in Wall Street with the Royal Bank of Canada in 2005. Trading for the bank, he discovered that he had increasing difficulty filling up his orders.

If he had wanted to buy 1 million shares of IBM from ready sellers, much of the sell orders would miraculously disappear just as he submitted his order. The outcome is that he could only fill a small portion each time he presses the buy button on his keyboard.

Perplexed, he set out to investigate. What he discovered was that the speed in which his order arrives at each exchange is different. For some exchanges, it took two milliseconds for his order to arrive; for others it took four. Now it takes 300 to 400 milliseconds for us to blink our eye, so that two thousandth of a second is actually rather inconsequential, or so we think.

High Frequency Traders

But to High Frequency Traders, that one millisecond is all they need. Using complex algorithms, HF Traders would be able to ‘see’ Katsuyama’s orders arriving at one exchange. They would then use their speed advantage to jump ahead of Brad’s orders at the other exchanges, buying up available IBM shares so as to offload them to him at a slightly higher price.

The speed at which this happens is way beyond human limits. For all the time you have spent reading this article thus far, hundreds of thousands of high frequency trading activity would already have taken place.

Trade orders are being transmitted though optic fiber cables at the speed of light. To create faster orders, the only possible way is to reduce the distance the order has to travel. Physical proximity is the greatest determinant of speed and the success of HFTs.

Stock exchanges understand this and are getting into the game by offering HFT firms the opportunity to house their servers in the same building as the exchange computers, for a fee.

Essentially, many exchanges deliver information faster to those who are willing to folk out a premium for the service. On top of that, they also allow HFTs, through a variety of order types, to jump in ahead of other potential buyers and sellers in the marketplace.

The net outcome of having these predatory HFTs in the market is that everyone actually pays more to buy and sell. The slippage may be miniscule per trade but in aggregate, they add up to billions.

Katsuyama and Investors Exchange  

From his perch at RBC, Katsuyama was in the best position to exploit and profit from HFT. Instead, he became increasingly disturbed at how stock exchanges, the very intermediaries who were supposed to price trades accurately and match buyers and sellers fairly were abetting the HFTs in their game of high speed arbitrage.

The cost to the market is significant, and everyone who does not operate on a HFT basis will be paying for it.

In 2010, he left RBC to set up his own exchange called the Investors Exchange, IEX. IEX touts itself as a ‘fair, simple and transparent market center dedicated to investor protection’. IEX does not allow co-location of HFTs’ servers in their premises. Neither do they reward HFT firms from pricing trades.

To further discourage HFTs from manipulating the orders, IEX had created a little shoebox sized contraption with 38 kilometers of fiber optic cable wound around it.

Every order that IEX receives would have found their way into and out of the box. It works like a speed bump; every order is slowed down, and this removes from HFT firms the very advantage they have sought to create.

The day after the FlashBoys’ launch, Brad and Lewis appeared on CNBC together. Entire trading floors stopped to watch the interview. It turned out to be one of the most viewed segments ever.

At the heart of the debate is a comment from Katsuyama that appeared in FlashBoys – The Market Is Rigged.

It does leave us with a sobering thought. What about other markets beyond the US? Are they ‘rigged’ as well? If it is indeed, what is in it for retail traders and investors?

Rigged Markets

The debate about IEX and FlashBoys is a microcosm of what the entire financial markets are about.

Since the beginning of time, speed and information flow has been a key element to successful trading. Faster and better informed traders entered trades before others could. It was their advantage and they profited handsomely from it.

Professionals and firms are always on the lookout for that little advantage they can eek out over their competitors.

As retail traders and investors ourselves, it is important to understand how severely disadvantaged we are.

We do not have the speed, the research capabilities and the information flow required for us to make perfect trades in the market. We have no business to be competing with financial institutions and fund houses in their arena.

Taken in this sense, the market is indeed heavily rigged against us.

Regulation vs Market Solution

The story of Brad Katsuyama in FlashBoys is a very telling one. Government intervention in the financial markets is now a given. In the event of a market dislocation, the instinctive reaction would be to regulate and disperse the inefficiency. Regulation also serves to limit the potential fallout when a huge financial institution fails.

The antithesis of government intervention is that of a market solution. Katsuyama has put forward a market solution for a deeply rooted problem in the US equity market. Rather than waiting for the SEC to compel exchanges to price trades fairly, he has created an exchange that actually does just that.

If the market accepts his solution, he will make a lot of money. The converse is true should the market reject IEX.

As participants in the market, we should never bank on being as fast or as informed as the professionals in order to make money from the markets.

One solution is to participate only in segments where we have an advantage in. This could include trading or investing in slightly inefficient markets (such as Singapore) where price discovery may not be as prompt as the more efficient ones and where speed is not as crucial.

As traders and investors, we are all responsible for our own market solution. If the market accepts our solution, we will make a lot of money.

And like Brad Katsuyama and IEX, the converse is also true.

 



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1Comment
  • Ppptp
    Posted at 23:39h, 20 December Reply

    I had that very same idea! Speed bumps to flatten out variances in speed.

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