The explosive declaration by acclaimed business author Michael Lewis that the world's largest sharemarket is "rigged" by high-frequency trading has sent Wall Street into a flux of chatter, self reflection and, in some cases, denial. In his famous book Moneyball, Lewis admired the quantitative skills used to recruit players to build a champion baseball team. Now he is taking aim at the numbers men.
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"The United States stockmarket, the most iconic market in global capitalism is rigged . . . by a combination of the stock exchanges, the big Wall Street banks and the high-frequency traders," Lewis says.
The provocative comments by the former Salomon Brothers bond salesman turned writer who has become famous exposing the rot in the finance sector will confirm the worst-held fears of regular investors: they are competing on an unlevel playing field that is tilted in favour of an elite few.
High-frequency trading firm Virtu recently revealed that it had just one losing trading day in 1238 days of trading. By using super-quick fibre pipes and computer-generated algorithms to buy and sell stocks, firms like Virtu are engaging in ostensibly riskless trading at everyone else's expense.
Lewis's remarks do need to be understood in context. He was promoting his new book, Flash Boys, on the prime-time Sunday evening United States television program, 60 Minutes.
The allegations, however, run much deeper than a simple publicity stunt. They raise genuine questions about the integrity of the world's capital markets, especially given that high-frequency trading is estimated to account for about 60 per cent of trade volumes in the US equity market. Even Goldman Sachs, long viewed as being at the cutting edge of profit-making activities in financial markets, has raised the white flag.
Pre-emptive move
In a pre-emptive move just days before Lewis released his book, Goldman suddenly came out to publicly support regulating high-frequency trading. The Wall Street bank anticipated the publicity storm Lewis's book would whip up, given the attention his previous best sellers, Liar's Poker, The Big Short and Moneyball received.
Lewis describes how high-frequency traders use sophisticated technology to make lightning-quick trades, fractions of a millisecond ahead of other investors, to gain a price advantage in the market.
Big investment banks that have invested in the expensive technology are helping to facilitate these trades for clients. Stock exchanges in the US and abroad are encouraging this activity by paying fee rebates to high-frequency traders who lodge large numbers of buy and sell orders on their trading platforms. The US regulator has been caught behind, unable to keep up with the implications of the rapid technology advancement.
The practice has earned a dirty reputation among more traditional investors, because of the "front running" the high-speed fibre pipes enable.
"It's crazy that it's legal for some people to get advance news on prices and what investors are doing," Lewis says.
High-speed firms pay top dollar to locate their systems in the same data centres as the exchanges, allowing them to plug in their computer servers and cut fractions of a millisecond off share orders.
Sophisticated algorithms
Such is the sophistication of the technology, high-frequency traders can anticipate another investor's stock order lodged in the system and buy the stock in advance and sell it to the original unsuspecting investor at a higher price.
It's like someone knowing you are going to walk down to the corner store at lunchtime and buy a bottle of Coke. They beat you to the store and buy the Coke at a discount price, and then sell the drink to you at the regular higher price. When this activity is undertaken millions of times to skim a small margin on each transaction, the profits can tally up handsomely.
Whether the practice is market rigging, as Lewis claims, is open to interpretation. The practice is currently recognised as legal by the US Securities and Exchange Commission.
Larry Kudlow, an economist and well-known US financial market commentator, says Lewis is exaggerating by calling the market rigged.
"There are imperfections and Mike Lewis who is a very bright guy has fingered some of these imperfections," Kudlow says.
"I never like to blame the technology because somebody is always going to come up with a better mouse trap."
High-frequency trading advocates have strongly denied Lewis's claims. They argue high-frequency trading is supporting other investors by adding liquidity, price discovery and depth to the share market.
Adding liquidity
Peter Nabicht, senior adviser to the Modern Markets Initiative trade group and former chief technology officer at high-frequency-trading firm Allston Trading, says the game is not rigged in the favour of professional traders who employ HFT.
"Rather, they work hard to compete with each other to bring liquidity to the markets, benefiting average investors," he says. But does holding stocks for a split second really support capital formation in equity marks?
Furthermore, faulty algorithms used by high-frequency traders were blamed by some for causing the infamous "flash crash". The Dow Jones Industrial Average plummeted about 1000 points or 9 per cent on May 6, 2010, before recovering the losses in a matter of minutes.
Eric Hunsader, founder of Nanex, a firm that collects data on market transactions, is angry the SEC hasn't stepped in and worries about the impact on investor confidence.
"The little guy is going to say, 'Why isn't the regulator doing their job and how can I trust them?' " he says.
However, retail investors are not the only traders who feel they are playing with one arm behind their backs.
Even large hedge funds, with access to detailed, up-to-date company information and with direct access to management of the firms listed on the stock exchange, believe HFT is costing them millions of dollars in the course of the year.
'You're going to get crushed'
Still, other seasoned long-term investors are less concerned about the "Flash Boys", accepting they will remain a part of the market structure.
"If you're day trading against these guys you're going to get crushed," says Peter Sorrentino, senior portfolio manager at Huntington Funds.
"If you're an investor and you're truly interested in profit for the long run, the Warren Buffett approach, then this is noise.
"It makes for great entertainment, but it really should not be central in your mind to investment-making decisions."
Regardless, Lewis's message about the unlevel playing field created by HFT is not likely to be forgotten in a hurry.
Wall Street insiders, including traders, investment banks, stockbrokers and regulators, have long been familiar with the issue. But now that Lewis has spilled the beans to Main Street, eager regulators will be under pressure to act to protect the perceived vulnerable.
Indeed, New York Attorney-General Eric Schneiderman this month opened an investigation targeting the relationship between stock exchanges and trading firms, under the guise of what he has named as "Insider Trading 2.0."
When Lewis picks apart a story in the way only he can, his captivating words can be a powerful prompt.
This article first appeared on AFR.com
