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.
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.