Monday, March 14, 2016

Wall Street High Speed Trading: Flash Boys and Michael Lewis

Michael Lewis wrote an article for April 2015 Vanity Fair, 'Wall Street's Flash Mob', which I found to be reflection of the changing times that we live in. Those with better trading platforms, faster technology and more advanced trading algorithms along with more money to pay to certain stock exchanges, profit at the expense of ordinary investors. High frequency trades(HFT) have been a problem in the U.S and also in Australia.

You may have heard of Michael Lewis, he is the author of Moneyball. Moneyball created a sensation in the baseball community. His book 'Flash Boys: A Wall Street Revolt' created a storm in the U.S stock broking industry. Unfair trading leads to erosion of investor confidence and allows one party to benefit at the expense of others. HFT has enabled unfair trades to be executed according to Michael Lewis, Brad Katsuyama and Eric Scott Hunsader. 

Advancement in technology has brought sweeping changes to the investment industry. Not only can you trade from home 24/7 across any stocks on any stock exchange due to the availability of internet and online trading platforms, you can pretty much buy and sell anything you want 24/7 globally. Electronic trading enables some companies to acquire market information milliseconds faster than competitors which gives them an advantage of millions of dollars.

The trading market has changed significantly since I also first traded. There is significantly more volatility across global markets and this is attributable to trades being automated and executed by algorithms and in widespread significant quantities. Those with faster access to data and trade executions profit at our expense. Other problems include flooding the market with automated orders causing crashes, layering, wash trades and spoofing.

Brad Katsuyama was a 35 year old trader at the Royal Bank of Canada who spilled the beans on the industry along with a few others. The complexity of the financial markets due to regulations meant that financial intermediaries stood to benefit more than the investors and corporations (the ultimate stakeholders of a stock exchange). Katsuyama founded the IEX trading platform along with other venture capitalists and asset managers to level the playing field. IEX has a 350 microsecond delay before executing trades. Goldman Sachs is also using IEX for their trades now. Eric Scott Hunsader, a gifted programmer says that the data indicates that IEX has the highest percentage of trades filled at the midpoint between the bid and ask of any exchange and this resulted in fairness.***

High frequency trades were being executed with computer algorithms at fast speed across roughly 60 private and public stock exchanges in the United States. Lewis writes:
"The Financial Industry Regulatory Authority announced it had opened 170 cases into "abusive algorithms" and also filed a complaint against a brokerage firm called Wedbush Securities for allowing its high-frequency-trading customers from January 2008 through August 2013 "to flood U.S exchanges with thousands of potentially manipulative wash trades(trader acting as buyer and seller of a stock to create the illusion of volume) and other potentially manipulative trades, including manipulative layering and spoofing." Layering and spoofing are off-market orders designed to trick the rest of the market into thinking there are buyers or sellers of a stock waiting in the wings, in an attempt to nudge the stock price one way or the other."
Athena Capital Research was fined for manipulating "the closing prices of thousands of NASDAQ listed stocks over a six month period". Lewis writes about banks creating secret orders for high frequency traders to enable exploitation of investors inside private dark pools. After an investor class action suit against some banks, some banks closed their high frequency trading operations and some closed their dark pools. 

The problems resulted from various stock exchanges selling retail stock market orders to high frequency traders. Also, high frequency traders were sold faster images of the stock market than the images that investors received. 

In Australia, the cost of high frequency trading is approximately one basis point, resulting in $110 million to $180 million in revenue across 12 months to March 2015** Dark pools account for about 25 to 30 percent of activity in Australian trading markets and exist to facilitate large trades. ASIC has been reviewing the industries due to concerns over conflicts of interest between how clients were being managed.

Definitions:
Dark Pool - Private exchanges for trading securities which are not accessible by the investing public. It is non-exchange trading, dedicated to large investors. 

High Frequency Trading- Powerful PCs transacting large orders using a trading platform at high speeds. Algorithmic trading with complex formulas.

Source:
* Vanity Fair April 2015, Michael Lewis 'Flash Boys: A Wall Street Revolt'
** Financial Review October 2015, 'High frequency traders shift to futures markets'
*** www.marketwatch.com, 17th February 2016, 'This man wants to upend the world of high frequency trading'

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