High-Frequency Trading

Apr 2, 2014 by

Dollar sign on Wall Street

On Wall Street, money rules.

Did you see the 60 Minutes segment this past Sunday titled “Is the U.S. Stock Market Rigged?” on high-frequency stock trading? I don’t like to gloat (well, maybe I do, a little), but as I wrote in Why I’m Wary of Stocks (published on Bargaineering 18 months ago), “I see algorithmic trading [of which high-frequency trading is a subset] as yet another way that Wall Street aims to rob the forlorn individual investor like me.

Turns out I was right. For once. 🙂

What’s High-Frequency Trading?

In a nutshell, high-frequency trading capitalizes on nanoseconds of advantage in the knowledge of imminent stock trades to make possible “front running” these trades.

And What’s “Front Running”?

According to Wikipedia, “front running is the illegal [emphasis added] practice of a stockbroker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers.” Wikipedia gives this specific example:

Suppose a broker receives an order from a customer to buy a large block—say, 400,000 shares—of some stock, but before placing the order for the customer, the broker buys 20,000 shares of the same stock for his own account at $100 per share, then afterward places the customer’s order for 400,000 shares, driving the price up to $102 per share and allowing the broker to immediately sell his shares for, say, $101.75, generating a significant profit of $35,000 in just a short time. This $35,000 is likely to be just a part of the additional cost to the customer’s purchase caused by the broker’s self-dealing.

High-frequency traders set themselves up technologically to know in advance—by minute fractions of a second—of stock orders, then do exactly what the broker in the example above does: buy the stock that you just ordered at the market price that you thought you were getting, then sell it to you at a slightly higher price, all executed in less time than the blink of an eye. The result for you is that you get the stock at a price slightly above what you anticipated. But for the high-frequency traders who execute this strategy on millions of stock transactions, the result is billions in front-running profit.

So if front running is illegal, why hasn’t anyone been prosecuted and these supercomputer controlled operations shut down? Excellent question, to which I have no answer other than that the SEC and Justice Department are hopelessly out-resourced by Wall Street.

A New, Honest Exchange

Featured in the 60 Minute segment is former Royal Canadian Bank executive Brad Katsuyama who did the SEC’s job for it and figured out how the high-frequency trading scam works. Fascinating stuff. This guy quit his high paying job at RBC to start a new stock exchange, called the iex, that has taken steps—namely utilizing a sixty-kilometer coil of fiber optic cable to foil high-frequency traders—to position itself as the only honest U.S. stock exchange.

60 Minutes’ “Is the U.S. Stock Market Rigged?”

Here’s the 60 Minutes segment (sorry for the commercial), required viewing in my opinion for anyone who owns stocks or is thinking of owning stocks. Also, check out Michael Lewis’s new book, “Flash Boys: A Wall Street Revolt“, about this topic.

What Will Be Done About High-Frequency Trading?

Now watch what happens next: After years of ignoring the issue and allowing investors to be ripped off for billions of dollars, Congress will conduct hearings and feign outrage (“I’m shocked, shocked to find that gambling is going on in here!”) and pillory the SEC and Justice Department and then outlaw a practice that’s already illegal.

No worries though on Wall Street. Its masters will always be years ahead of any regulator or politician in devising new and creative ways to continue siphoning off small investors’ savings and keep the bandwagon rolling.

Is Your Confidence Shaken?

Does the high-frequency trading scandal alter your view of stock investing?

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