Are Average Investors Getting Bilked by Wall Street Supercomputers?

While high-frequency trading has propped up volume in the market, the method rewards shortsighted investors looking to make a quick profit

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As long as there has been a Wall Street, there have been those seeking to skim a little (or a lot) off the top of the vast wealth changing hands in the markets each day. Though capital markets in America are by and large very successful at efficiently allocating resources from investors to deserving businesses, wherever there is great wealth, corrupt forces will seek to exploit it. For example, in the 1990s the Nasdaq stock exchange was embroiled in a price-fixing scandal in which securities dealers were found to be colluding to keep bid-ask spreads — or the difference between the prices at which a stock is bought and sold — high in order to bolster profits.

Partially in response to scandals of that nature, the stock market — with the blessing of federal regulators — has radically evolved. Once dominated by large not-for-profit exchanges like the New York Stock Exchange and Nasdaq, America’s capital markets have, over the past decade, become highly decentralized. The majority of trading takes place in a series of for-profit, electronic venues that compete fiercely to facilitate trades and increase profits. This fragmentation was accompanied and encouraged by the rise of high-frequency trading, a term that describes the use of high-powered computer programs to make hundreds or thousands of trades per minute in an attempt to exploit miniscule inefficiencies in the markets.

(MORE: High-Frequency Trading: Wall Street’s Doomsday Machine?)

One way high-frequency traders like to make money is by watching large institutional investors — the sort that manage money for your 401(k) or public pension funds — and attempting to predict how they will go about making investments. For instance, a computer program might try to interpret moves in the market to see whether a large fund is in the process of buying up a large position in a stock, and then jumping in ahead of those trades before selling for a profit moments later.

I’ve written previously about how some critics of high-frequency trading are worried that its dominance of Wall Street poses systemic dangers to the nation’s financial system. But there are those who also believe that such practices as described above are actually just a sophisticated way for traders to use high-powered computer programs to extract wealth from the stock market without adding value to it in any way.

Joe Saluzzi and Sal Arnuk, co-founders of the brokerage firm Themis Trading, have been vocal critics of high-frequency trading for several years. In June they published the book Broken Markets, which characterizes high-frequency trading as just another way to soak America’s capital markets.

Arnuk and Saluzzi argue that the evolution of exchanges from not-for-profit “quasi utilities” to for-profit businesses has distorted incentives so that exchanges are now beholden to high-frequency traders, who make up a large share of their business. They write:

Sadly, today, the primary purpose of the stock market is not capital formation. Investors are an afterthought. The primary purpose of the stock exchanges has devolved to catering to a class of highly profitable market participants called high-frequency traders or HFTs, who are interested only in hypershort-term trading, investors be damned. The stock exchanges give these HFTs perks and advantages to help them be as profitable as possible, even if doing so adversely affects you, the investors, because HFTs are exchanges’ biggest customers.

These supercomputers are the source of so much business for stock exchanges that they will sell or give away a lot of data about who is trading what stocks and when. The exchanges also make money by allowing trading firms to “co-locate” their computers at the same facilities where exchanges maintain their computers so that high-speed traders can get information about trades milliseconds sooner.

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Advocates of high-speed trading argue that these computers are doing the valuable service of increasing the total number of trades occurring in the market at any given time, or what those on Wall Street call volume. The idea is that the more volume and liquidity there is in the market, the more accurately prices will reflect the value of a given security, and the cheaper it is for investors to transact. This is broadly true. Volume over the past 20 years has increased in the marketplace, and it is cheaper than ever to conduct trades.

But as we saw in the 2010 flash crash, liquidity can vanish quickly when high-frequency trading programs sniff a bit of trouble. And while bid-ask spreads have narrowed, high-frequency trading is wildly profitable. That profit has to come from somewhere, and since many of these firms are short-term traders, they’re not making their money by doing the hard work of deciding which companies are deserving of capital and which aren’t and sticking with those worthwhile companies as they grow.

They are making their money by taking advantage of inefficiencies in the market — and as Arnuk and Saluzzi would argue — through unfair advantages given to them by exchanges. Those profits are coming directly out of the pockets of long-term investors. If transaction costs have been reduced by additional volume from high-frequency traders, and these same systems are making investing more costly for investors in other ways, how does that enhance the markets? Add to that the volatility high-frequency trading has injected into the system, and the idea that these practices need to be reined in becomes much more appealing.

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26 comments
ChiefBoardOp
ChiefBoardOp

The only disadvantage is the classic garbage in garbage out in the process  should inaccurate numbers go in  bad decisions are made  by algorithmic high speed.  or classic garbage in  garbage out at the speed of light adding to a gamble of wall-street Day trader style  stock wagers..  since its not buy and hold that reduces it to little more than a long shot in a horse race bet.

proletaria
proletaria

"Though capital markets in America are by and large very successful at

efficiently allocating resources from investors to deserving businesses..."

Citation needed.

John Doe
John Doe

The biggest problem is that we still have greedy, lazy and worthless people profiting from doing nothing more than sitting in front of their computer feeling as though they've 'earned' every penny they have. It's time to eliminate the non-producers from society to make way for those who actually drive society and civilization forward. Whether it happens at the end of torches and pitchforks or through legislation matters not, as long as the leeches and scum are removed from the planet, then just like they believe the ends justify the means. Death to Wall Street and Hollywood Blvd.

adam_onge
adam_onge

If they could only break the speed of light. Seriously!

The investment banks are building their servers nano-seconds away from the exchanges.

Tachyon trading is coming soon to a bank near you, as Hari Seldon from Streeling University on Trantor predicted.

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Bharat Lm
Bharat Lm

Lot people feel think that we are anyways using computer.... but I feel author is right . Simple case , a game of Chess when you play with super computer ( Algos). It is true Chess is very complex game but we all know in general we will never win against computer. So in general here as well normal Investor it to loose.  * Another point when you are not risking you money in company but rather in sentiments mood etc ( usually combination)  it matter what % you put on these factors. If these Algos are supporting Sentiments/Mood even at 30% ,  at 

the speed which they trade , Stock Exchange becomes game of sophisticated poker where big Computer ( algos ) can stay and people like us will always get defeated. 

eifg
eifg

I have no problem with HFT if the exchanges treat those firms the same way they treat anyone else who is buying or selling stocks.  The NYSE recently agreed to a $5 million fine (of course no admission of wrong doing) for giving preferential treatment to HFTs. I believe they were letting them see the order flow a fraction of a second before the public allowing them to get in front of orders.  I may be wrong about that but I belive it is what the article said.

Schlott
Schlott

 

A simple way to solve this is to require a market bid to be placed for a minimum of one minute.  That way the fake bids would be exposed as they would not want to hold them that long lest they be filled.  They could not pull the rug out from under the market if they were required to hold their bid.  Contractors are required to hold their bids valid for a period of time.  Why not brokers.  A simple one minute requirement would eliminate a good share of the HFT games we pay the price for. 

Now ask yourself why this simple solution has not been enacted yet.  It exposes who holds the power.  The banks versus the people.

 

Max Goldberg
Max Goldberg

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dollar terms for years. But it has dropped in 

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Max Goldberg

Richard Sloat
Richard Sloat

 The fact that the high frequency trader can deal in fractions of a second with fractions of a cent means they are given a first choice on all trades.  I have tried to sell stock and see my ask on the screen when someone wants to buy at my ask, I am undercut by .0001 cent. The same is true on the buy side a bid .0001 over  the ask price.  This happens  frequently.  Would Sotheby's or Christie's permit such trading.  Giving   first choice on a trade to a high speed trader at a fraction of a cent difference.. This is not how an auction system should fairly work.

Richard Sloat
Richard Sloat

The real scandal of high frequency trading is that the stock market auction is rigged to let them steal a trade if they want. By trading in fractions of a cent they can interrupt a trade by bidding .0001 cent more or less than the average  investor.  I see a stock say selling for $10 on my trading screen, bid the $10 and see it was sold for $10.0001.  If I am selling at $10 my bid as the ask on my screen but then it is sold for $9.9999.  This happens thousands of times a day.  The high speed raiders get first call on any trade!!!  The system is rigged in their favor!!!

LoudRambler
LoudRambler

 Let me get one thing straight: high frequency trading is not driven by supercomputers alone. Trust me, most of the wealth management companies use computer-driven analysis in one form or another.

 What high frequency trading is driven by is the unfair advantage in network latency based purely on server location that allows Wall Street or, in most cases, Chicago Mercantile Exchange to post a lot of bogus call/put orders and pull them instantly to see how the market reacts.

 On top of this, quite a number of wealth management fund don't rely on stocks as their main investment; and, as far as their portfolio decomposition go, a lot of things in there don't have enough liquidity to warrant high frequency trading. Heck, if some of that stuff would be traded at least daily, it will already be high frequency (think bonds). High-frequency trading hurts mostly your Joe the Investor, who never looks past Samp;P500 and Nasdaq stock, has mostly stocks in his portfolio "because they appreciate faster", and, on top of things, is sure he can beat the street.

Nonaffiliated
Nonaffiliated

I would appreciate the author backing up his claim that "high-frequency trading is wildly profitable".   Often authors use such subjective terms when they really don't have any facts. 

HFT's are driven by computer algorithms that analyze the market for opportunities.  People have been using mathematical analysis to make stock purchase decisions since the PE ratio was invented.  The only real innovation here is that the algorithm is authorized to actually make a transaction instead of making a recommendation to a human.  They're not doing anything new, they're just doing it faster. 

So, what's the real complaint?  That they make money and provide no useful service.  The only way they make money is to find shares that are incorrectly priced.  If the price is too low, they buy.  If it's too high, they sell.  That's what all investors do.  The service HFT's provide is to more accurately price the investments being traded.   Investors typically hold their stocks for years.  Traders hold for minutes to weeks.  HFT's may only hold for a second.  So?  Everyone still buys and sells voluntarily at a mutually agreed price. 

Can the  HFT's can figure out what your mutual fund is doing and get there first (front running)?   If your mutual fund is large enough and idiotic enough to try and dump it's 5% stake in a company over the course of an afternoon, then yes, you may pay a price.  However, if the fund trades in normal volume, the orders are just part of the noise that makes the price anyway.  No individual account should represent a market-moving force.

I think that stock market investing has reached the point long passed in chess...computer algorithms produce better results than humans.  That may indeed be bad for the individual investor, but I don't think it's a bell that can be unrung. 

zza371creek
zza371creek

I don't think high frequency traders add anything to the market. In fact many type of trades make our markets more and more unstable and  inefficient. I know many traders make money not by making good investments in companies but by looking for some kind of patterns in how big funds trade so they can buy in before the fund buys in.

Basically these guys are stealing other people's money by using holes in the systems. Most people don't know this because the funds don't report how much they paid for everything vs the cheapest price that month.

sixtymile
sixtymile

Even just calling them "inefficiencies" -- this is part of their scam. It should be something like obvious that consuming these small, brief, otherwise undetected inefficiencies in the market that would be expected to become detectable and lead to trading decisions by investors is essentially skimming the til and sucking the market opportunity for everyone else.  This is where our expected retirement savings are going. To the extent that mutuals are the safest option for average investors and the micro-traders are in middle of most of these these trades, yes we are clearly being robbed.  And making it "cheaper to trade" is just offering discount fare to Vegas.