“It’s not American; it’s not even capitalism. It’s cheating.”
The first of the quotes above is the final paragraph of a letter sent this week by Charles Schwab and Walt Bettinger – the founder and chairman, and the president and CEO, respectively, of the Schwab brokerage firm, one of the largest such businesses in the US – to their clients. The second quote is from Jon Stewart, on his popular TV show, The Daily Show, this week.
They are both discussing the same phenomenon, namely HFT. If you haven’t met this anagram before, then be aware that it stands for high-frequency trading, and expect to hear about it a great deal from now on.
Both Schwab and Bettinger, from their professional perspective, and Stewart from his popular one, are actually saying the same thing: HFT undermines the integrity of the markets because it involves systematic cheating.
Stewart is just plain shocked – not Captain Renault in Casablanca-style “I’m shocked,” but genuine horror – that the most hallowed financial institution in the United States, the stock exchange, is now rigged so that individual investors lose every day and a few firms with very expensive equipment win – every trading day.
This win/lose structure has nothing to do with investing; it’s all about trading. In order to invest, you have to trade; i.e., to buy and/or sell shares. That’s where the rigging is done, in the process of buying and selling. In a fair market all participants have access to the same information – not just about the companies whose shares are being traded, but about the trading itself; i.e., what are the current prices to buy and sell, how many shares are being bid and offered, etc. If you know the latest price sooner than the next guy, you have an advantage. If the law recognizes that advantage as unfair, then using it is illegal. But even if it is not technically illegal, if it exists and is systematically exercised – in other words, if the advantage is always held by the same small group of entities, who take advantage of everyone else in the market – then the market is rigged.
In the 18th century, you could know prices days ahead of other people. In the 19th century it was hours, and by the 20eth it was minutes, at best. By then, the markets had “matured” and government regulators had been installed to prevent the use of advantages such as inside information or “front-running” – trading on the basis of knowing the price before most other market participants.
In the 21st century, with universal access to real-time price quotes, many people believe they are on a level playing field with the biggest institutional players. Such persons are benighted fools, and they are being ripped off every day, on every trade. But because the rigging is based on a time advantage of milliseconds and even nanoseconds (whatever they are), and the price gouging is in fractions of a cent and spread very widely over millions of shares, the victims feel nothing and remain unaware. This is an idyllic situation for the operators of HFT firms.
HFT is actually far more complicated than that, but the rest is all technical and technological detail. The existence of HFT and the problems it causes is at least five years old; the Zero Hedge blog exposed them in April 2009. However, hundreds of items at ZH and elsewhere in the blogosphere, supported by detailed evidence, had no overt impact.
However, the publication of one book, Flash Boys: A Wall Street Revolt, has changed all that, leading to a week of extraordinary drama on financial and even mainstream American TV, as the Jon Stewart quote illustrates.
The book is written by Michael Lewis, author of, inter alia, Liar’s Poker, which explained and exposed the world of bond trading in the 1980s. Lewis knows all there is to know about how Wall Street works, and he has delighted in running rings around a series of opponents – mostly heads of HFT firms – against whom he has been pitted in televised jousts almost every night.
The book has been adapted into a (long) article in The New York Times Magazine. If you want to understand the markets, capitalism and the US today, you should watch some of these televised face-offs – preferably after reading at least the article and the Schwab letter. If you can’t be bothered, that’s fine, too: You deserve what they’re doing to you.