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High-frequency trading runs over a rigged market: Barry Ritholtz

The math on trading is simple: It is a zero-sum game

Mar 31, 2014 @ 10:42 am

By Barry Ritholtz

high-speed trading, hft, michael lewis, markets, stocks, regulators, 60 Minutes
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Michael Lewis (Bloomberg News)

On "60 Minutes," author Michael Lewis made a bland assertion: High-frequency traders, he said, working with U.S. stock exchanges and big banks, have rigged the markets in their own favor. The only surprising thing about Mr. Lewis's charge was that anyone could be even remotely surprised by it.

The math on trading is simple: It is a zero-sum game. One trader's gain is another trader's loss. Only in the case of HFT, the losers are the investors — by way of their pension funds, retirement accounts and institutional funds. The HFTs' take — the “skim” — comes out of these large institutions' trade executions.

The technology behind HFT may be complex, but the math is that simple. Once the Securities and Exchange Commission allowed stock exchanges to share with traders all of the unexecuted incoming orders, it was hard not to make money by skimming a few cents or fractions of a cent from each trade. Several years ago, the founder of Tradebot, one of the biggest high-frequency firms, had said that the firm had “not had a losing day of trading in four years.” The firm's average holding period for stocks is 11 seconds.

Any professional trader can tell you that his job is to manage risks. It is a statistical certainty that a percentage of trades will be losers. You are establishing a position with an unknown outcome. Sometimes they go your way, other times they go against you.

How is it possible that one of the largest high-frequency trading firms executes millions and millions of orders for four years without ever having a down day? The short answer is what they do is not trading — it is skimming. I call it legalized theft. High-frequency trading is a tax on investors, encouraged by the exchanges, allowed by the SEC. It is prima facie proof that something is amiss.

Regardless, to those of us who recognize HFT as a problem, Lewis's comments are good news. He is out promoting his new book, "Flash Boys: A Wall Street Revolt" (W.W. Norton & Co., 2014) As one of America's pre-eminent chroniclers of all things financial, his comments will reach a wide audience among the public and politicos in Washington.

This isn't the first book on the subject. If you want to dive into HFT, I would suggest reading Dark Pools: The Rise of the Machine Traders and the Rigging of the U.S. Stock Market, by Scott Patterson (Crown Business, 2012). For a practitioner's perspective, see Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio, by Sal L. Arnuk and Joseph C. Saluzzi (FT Press 2012).

It is interesting to note that the rigging theme is consistent with everyone who looks closely at this subject. My colleague Josh Brown notes that markets haven't become rigged, they have always been rigged. What is different is the ability of high-frequency traders to see other people's orders, jump ahead of them, and then sell that exact same stock to them, at a higher price. It is the ultimate market-skimming operation.

The specialist system that predated HFT had its flaws, as we saw in the 1987 stock-market crash. But it also had one crucial redeeming factor: A human being stood ready, willing and able to make a market in a stock when other buyers and sellers disappeared. HFTs, on the other hand, have no such obligation. When things get rough, they unplug their machines. This makes their claims of added liquidity laughable. They are the centerpiece of a flawed system without any socially redeeming qualities.

I am looking forward to reading "Flash Boys." I hope our members of Congress and the folks at the SEC do so too.

(Barry Ritholtz is a Bloomberg View columnist writing about finance, the economy and the business world. He is a professional money manager and started the Big Picture finance blog in 2003. This post first appeared on Bloomberg.)

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