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Flash Trading

In 2008 very few people had heard of credit default swaps, overnight repos, or collateralized debt obligations (CDOs).   Many of the firms that brought those financial creations to the market have brought dark pools and high frequency trading. Firms doing high frequency trading execute over half the orders in the stock market and probably place over 95% of the orders. Dark pools account for another 25-30% of trades. That leaves less than one out of four trades being done “the old fashioned” way. I believe it is important to understand what is going on and to keep the focus on the longer-term to build wealth and income.

I first licensed as a financial advisor in 1986 (we called ourselves “stock brokers” in those days). There was the New York Stock Exchange, the American Stock Exchange, Over-The-Counter (OTC), and some smaller city exchanges like Philadelphia and San Francisco. Chicago traded options and futures. Individuals would “buy a seat” on the New Stock Exchange giving that person the right to make a market in often just one stock. That person would match buy and sell orders for that particular stock. Brokerage firms would hire “Floor Brokers” who would receive orders from the firms and run to the chair and offer or bid for a stock. Most people are familiar with the pictures of the stock exchange with the mass of brokers surrounding a market maker shouting their orders to buy and sell.

That picture is long gone. Now it is computers that run the matching. Orders are delivered and cancelled in microseconds (there are 1,000,000 microseconds in one second). Over half the trades are computer generated through algorithms which are written to be run with no human intervention. This is the territory of high frequency traders (HFT). The HFTs make hundreds of billions of dollars taking advantage of high volumes of trades and small incremental profits. All of those come at the expense of you as an investor. It may not be much as a percentage of each trade, but in the aggregate, it is significant.

To visualize the magnitude there is a company by the name of Spread that spent between $200 and $300 million to build a new fiber optic line from Chicago to New York City just to save 4 milliseconds (.004 seconds) in transmitting stock market data. Normal fiber optics networks are built along rail tracks and right of ways that are not the straightest path. Data travels at the speed of light through the optical fibers. By building a straight optical line Spread was able to lease the fiber optic cable for upwards of $20 million per year to a number of companies. All of that just for 4 thousandths of a second advantage over the trading of other firms.

Times have changed. Instead of a few exchanges, there are over a dozen that trade stocks. They compete against each other for orders. It would seem logical, and big brokerage firms will argue, that this competition increases liquidity and saves money for investors. I doubt it.

There was a time only a few years ago when I would place an order for a block trade of 100,000 shares and set the limit at the offer if I was buying or the bid if I was selling. The order would execute at the limit. But in the last few years I have placed orders at the offer or bid, but did not get filled at that price. I had to put the order in at 5 to 10 pennies above the offer or below the bid depending on whether I was buying or selling. Until I read the book Flash Boys by Michael Lewis I did not understand why the change.

What I now realize is my order is routed to an exchange but before my order gets to the exchange high frequency trading algorithms will scoop in and execute trades in front of mine forcing me to pay more if I am buying or sell for less if I am selling. It is a disadvantage for my clients. It may only be a few cents a share for each transaction, but it is at the expense of my clients.

I am a longer-term investor and look for significant gains in the stocks I buy for portfolios. A few pennies is not going to make a big difference in what we make on our portfolios, but over time, that will make some difference.

In addition to the high frequency traders, there are the dark pools. Prior to the computer age, all trades used to be done on the physical exchanges. But with the advent of computers and as volumes increased, very large trades were done away from the exchanges and reported when complete. That was the infancy of the dark pools. At that time if a large order came to a brokerage firm, the brokers would go out and find the other side of the trade and when the buying and selling sides were lined up the trade would be reported. It was not often the matching occurred at the moment the order was initiated. It took time to line up the other side.

That has given way to the dark pools. The big firms will do trades perhaps acting on both sides of the transaction as seller and buyer. They are not required to report the time of the trade or where the trade took place—just that a trade took place and at what price. In the book, Flash Boys, Michael Lewis recounts the story of the Merrill Lynch analyst who was charged by management to show their dark pool was good for the markets. What he initially reported to management was the dark pool was harming their clients. That was not the conclusion Merrill management wanted to hear so they kept sending the report back until it was changed to show what management wanted.

Mary Jo White, the head of the Securities and Exchange Commission has delivered a couple public speeches where she has had harsh words for High Frequency Traders and even harsher words for dark pool operators. The SEC will probably take some action to curb high frequency trading and maybe make the dark pools more transparent. But as we have seen over the past decades, Wall Street hires very smart people who use their intelligence to game the system. Even curbs on HFT and dark pools will probably only lead to other manipulations of the markets.

For me it is best to understand this and to invest in such a way that even with these manipulations clients can do well and maybe even benefit.

For more information on all of these topics, I encourage you to listen to About Money, a weekly podcast and radio show. You can also follow us on Facebook and Twitter for blog updates, podcast news, and more!

I want to hear your opinions; please leave a comment below and let me know your thoughts.

Until next time,

Mike

 

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