The stock market is rigged, and regular investors are getting the short end of the deal. Or so says the hype surrounding the recent controversy over high-frequency trading, known as HFT.
The maelstrom broke out after the March 31 release of Michael Lewis’ book “Flash Boys: A Wall Street Revolt,” which follows Brad Katsuyama, who was a trader at the Royal Bank of Canada when he noticed strange patterns in the stock market. Katsuyama spent years performing tests and hunting down answers to figure out what these anomalies were and how to stop them.
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Eventually, he concluded that the culprits were high-frequency traders and their superfast computer algorithms. These computers were so fast that, using legal but very fleeting information, they could harness milliseconds of speed to notice big trades after they were entered but before they were executed.
In other words, in the time that it took traditional brokerages to execute those trades, with the click of a mouse, these speedy agents could quickly snap up the same shares and resell them to the initial buyer for more.
How HFT Can Make Traders Money
Even though the price difference was miniscule—sometimes fractions of a cent—this invisible tax added up. For example, Katsuyama and his team saved $29,000 on a single trade when tinkering with algorithms to cut out the silent middleman. As The New York Times Magazine puts it, “It sounded small until you realized that the average daily volume in the U.S. stock market was $225 billion. The same tax rate applied to that sum came to nearly $160 million a day.” And because HFT is predicated on trading massive volumes, the practice is widespread: By some estimates, HFT accounts for more than half of all U.S. trading volume.
In anticipation of the book’s release, New York Attorney General Eric T. Schneiderman called the practice “Insider Trading 2.0” and major retail brokerage Charles Schwab has condemned HFT as a “cancer.” The FBI and the Securities and Exchange Commission have announced that they are investigating HFT and Katsuyama himself has publicly stated that the market is rigged in favor of high-frequency traders. The backlash against these trading strategies has been so serious that HFT firm Virtu Financial decided to postpone its initial public offering by at least a week because of the negative press.
Is It As Bad As It Sounds?
High-frequency trading’s proponents argue that the practice is simply a more efficient way to analyze and react to the market. “Somebody here has just invested in a better mousetrap,” Charles Jones, professor of finance at Columbia Business School and an HFT expert, told The Christian Science Monitor. "So why shouldn't they get a return on that better mousetrap?"
Critics contend that the risks of HFT outweigh the benefits. In the past several years, there have been a few sudden market lurches in which stocks inexplicably plummeted; HFT has been a chief suspect. "Our sense is that this relentless pursuit for speed, to get there faster, has a destabilizing effect on the marketplace and the market's infrastructure," Andrew Brooks of T. Rowe Price tells Rhode Island Public Radio.
Meanwhile, in a direct response to HFT, Katsuyama—who quit his lucrative job to solve this riddle—has started a movement that's gaining momentum: He created his own stock exchange, and major players like Goldman Sachs have since signed on.
The exchange, called IEX, refers to itself as “dedicated to institutionalizing fairness in the markets,” and pledges to “provide a more balanced marketplace via simplified market structure design and cutting-edge technology.”
And so we get to the crux of the issue: If the markets are rigged against us, should we pull our money out of this flawed system entirely? Should we try to move all of it to Katsuyama’s new exchange?
What You Should Do
At the end of the day, unless you’re managing a tremendous fortune and making tons of frequent trades, this controversy probably won’t significantly affect you. LearnVest is a proponent of long-term investing, especially for retirement, because it’s been shown to be the most rewarding strategy over time.
As Taesik Yoon aptly writes for Forbes, slight differences in investment prices due to HFT won’t make a significant impact on a buy-and-hold long-term investor: “It really makes no material difference if you buy a stock for $14 per share or $14.02 per share. If it climbs to $20 in a year, you’re only talking about a difference between a 42.86% return and a 42.65% return.”
Dollar amounts aside, we understand the desire not to be taken for a chump. Only registered broker-dealers can subscribe to IEX, but if the idea of being cheated out of a few cents really gets under your skin, you can search the list of broker subscribers to see if yours participates. If not, you can always ask your broker to route your trades through IEX. If you feel passionately about this issue, you can also support IEX’s political initiative. (It goes without saying that IEX stands to gain through your advocacy, so always use your judgment.)
The most important takeaway of all is that this hullabaloo shouldn’t keep you from investing in your future, especially since saving enough for retirement is already such hard work. As Forbes contributor Gene Marcial notes: “If you track the market’s various major stock price charts over these many years, they have all been on the rise and climbing to new all-time highs—rigged or not.”