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About That Rigging Claim

Michael Lewis takes on the stock market.

John Rekenthaler, 04/02/2014

High Dudgeon
Michael Lewis has taken the high moral ground. In publicizing his new book on high-frequency traders, Flash Boys: A Wall Street Revolt, Lewis has dominated this week's investment news, first with Sunday's 60 Minutes interview and then with a long excerpt in The New York Times. In both the interview and the Times article, Lewis claims that the U.S. stock market is "rigged."

Uh-huh.

To judge from the Times excerpt (I have not yet read the book), Flash Boys is Lewis at his mesmerizing best, detailing how high-frequency traders, or HFTs, burrowed into the marketplace, operating so quietly and surreptitiously that even investment giants like T. Rowe Price and hedge fund giant David Einhorn did not realize what was occurring. They knew that their trades were not getting processed as they expected and that something odd was happening, but they did not understand why. 

We learn that HFTs profit through an information advantage. Even if simultaneously placed on every stock exchange, trade requests do not arrive at each exchange at precisely the same moment. The length of the data transmission wiring between the broker who places the order and the exchange varies, which gives the HFT its feeding opportunity. In the very short amount of time that it takes light to travel the extra distances between the exchanges, HFTs pounce.

As an example, consider a large buy order for Microsoft MSFT at $41.50 that arrives at the first exchange. An HFT will read that order, will anticipate that this buy request will temporarily boost Microsoft's stock price, and will place its own buy order for Microsoft at $41.50 at the remaining exchanges. A micro-fraction of a second later, the initial buy order arrives--but can no longer be filled. There is no remaining Microsoft stock selling at $41.50. It now costs $41.51 or $41.52.

Is that rigged?

It is in a trivial sense, in that HFTs extract profits from the system in a way that you and I cannot. In that aspect, however, HFTs are neither new nor unique. Stock market makers, who profit by supplying liquidity, in a fashion that you and I cannot match, existed long before HFTs were invented. So, too, did retail stock brokers, who were protected from stock commissions until 1975, and who even for decades after that served as unavoidable toll collectors. Want to buy a stock? Pay the toll.

Thinking Small
However, there is a difference between HFTs and previous profit extractors: The HFT effect is smaller.

is vice president of research for Morningstar.

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