The Associated Press

Flash Trading: Where Your Money Goes to Die

An FBI investigation into high-frequency trading on Wall Street is the first bit of regulatory medicine.

The Associated Press

Wall Street's high-frequency trading is under investigation.

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This week, best-selling author Michael Lewis released his new book "Flash Boys." Lewis reveals how Wall Street insiders use a practice called high frequency trading to profit at the expense of their clients, the ordinary investors. In a modern day version of “The Emperor’s New Clothes,” Lewis strips away the self-serving rationalizations of high-frequency traders, who pay the stock exchanges millions to gain a few milliseconds of advantage in reacting to the flow of orders.

Lewis documents a set of trading practices that amount to an exploitive practice called “front-running.” In front running, a broker or other intermediary jumps in front of the client’s orders before the order can be executed. Front running imposes an artificially large bid/ask spread on every trade. The amount per trade isn’t much, just a few pennies, but by front-running millions of trades day in and day out, the insiders enrich themselves while slashing the returns available to retail investors.

Ironically, front running is illegal when it’s done by individual human beings exercising discretion one trade at a time. But it’s completely legal to implement a computer system to front-run trades automatically.

[Read an interview with author Kevin Roose on the "new" Wall Street.]

Everyone remotely close to the stock market has known that flash trading has been going on for years. Any retail trader can see it in action. All you have to do is place a limit order between the existing bid and ask, and then watch the prices dance away from you as soon as you hit the enter key.

The amazing thing about this story is not that high-frequency trading has been fleecing investors for years, it’s that everyone important has been ignoring the story. The major financial media have been ignoring it because of lucrative advertising relationships with the market participants who profit from the practice. Federal regulators have been ignoring it because they are under intense pressure from senators and representatives who take campaign contributions to look the other way.

But Lewis has a huge following, and the spotlight he cast on this sordid practice was too bright to ignore. The day after Lewis’s book came out, the FBI announced it was launching an investigation into high-frequency trading. The timing is more than a little suspicious. Clearly, they had the information at hand to warrant the investigation; they were only waiting until they were pushed to act. Like Captain Renault in the classic film "Casablanca," they were “shocked, shocked to find that gambling is going on in here.”

[See a collection of political cartoons on the economy.]

The case of high-frequency trading can help us understand why competition doesn’t always work, even in a market that appears to have a lot of competitors. Competition is supposed to lead to efficiency, according to classic economic theory, but it didn’t in this case.

The problem starts with the fact that investors and insiders want different things from the stock exchange. Investors want reliable, efficient execution. That means low fees and a low spread between bid and ask price. But insiders want high fees and a high bid/ask spread, because that boosts their profits.

Under ordinary circumstances, competition between different exchanges like the New York Stock Exchange, AMEX, NASDAQ and recent entrants, should drive down fees and reduce spreads. Fees have definitely fallen. Nominally, spreads fell too, though the actual spreads, after taking high-frequency trading into account, have inched upwards.

[See a collection of editorial cartoons on the IRS Scandal.]

So why did competition not lead to greater market efficiency? The answer is a combination of client ignorance and inside deals made between market participants at the client’s expense. The first problem was that customers were not paying attention to where and how their orders were executed, and therefore brokers could route their orders wherever they wished. Brokers encouraged this ignorance, failing to tell clients the magnitude of the difference, and failing to give customers tools to direct the routing of their orders. Brokers began to accept substantial payment for order flow; the high-frequency traders would pay brokers like Schwab, TD Ameritrade, and others to direct the clients’ orders to where the high-frequency traders could scalp them.

Unfortunately this type of practice – where insider deals between parties in a market work to the detriment of the customer – happens in many markets. For example, when doctors send the patient to a testing lab in which the doctor has a financial interest, the patient pays more without getting anything more in return. When real estate agents steer clients to trust services, title companies and appraisers with whom they have a side-deal, the client pays more than the fair market value of the services involved. Many complex marketplaces are subject to predations like this.

At one time, it was thought that these problems could be fixed with disclosure. Transparency alone would solve the problem. But the firms involved have mastered the art of burying the disclosure in fine print that nobody reads and presenting the disclosure at a stage in the transaction when the client is too distracted to notice. Disclosure alone is not enough.

[See a collection of political cartoons on Congress.]

It’s going to take strong regulatory medicine to restore real competition to these complex and high-stakes marketplaces. Competition is hard to maintain in a marketplace full of players seeking opportunities to collude. But if we want financial markets to serve the real needs of investors and the real needs of companies seeking capital, we are going to have to make markets truly competitive and truly efficient. The FBI investigation is an important first step. Now, hopefully, Lewis’s book will goad the other regulators to do their jobs. It will be a tough fight.