In a previous blog, I shared the three pieces of financial advice that made a difference to way I thought about, earned, spent, and invested money. As I pointed out, because savings and bond rates are so low, Americans are turning increasingly to the stock market to save and invest their money. Even the pension funds and 401K accounts offered by employers are heavily invested in the stock market. What you don't know about the stock market, however, is that it is no longer a place populated by men in shirtsleeves yelling out bids and offers on behalf of their customers. In the 21st century, it has become a place populated by intelligent computing systems that run sophisticated algorithms written by the best and brightest "quants" (financial mathematics experts). And those who don't know how these systems work can quickly fall prey to them.

The algorithms that have achieved recent notoriety since the publication of Michael Lewis' Book Flash Boys are collectively called High Frequency Trading (HFT). These are "algobots" that make stock trades at blindingly fast speeds—on the order of microseconds. And by doing so, shave billions from the stock market, often at the expense of legitimate buyers and sellers. Here is how it works:

High Frequency Trading in Plain English

Buy and sell orders don't show up in the market t the same time, so there is an intermediary that bridges the gap—traders who buy from the seller and sell to the buyer. Suppose you want to buy a large share of stock XYZ—say, 10,000 shares. You put your order in with your broker who tries to fill that buy order by buying shares on the stock exchanges. If there is a seller who has 10,000 shares to sell, then the transaction should be made. The seller sells, the buyer buys, and the brokers for the buyer and the seller collect their transactions fees. If only smaller lots are available across several exchanges, then the broker will buy these smaller lots in order to fill his customer's order for 10,000 shares.

But what if your broker tried to buy shares of XYZ stock that appeared to be for sale on one exchange, but the share lots mysteriously disappeared when he tendered his offer to buy? And then the same share lots appeared on another exchange—but at a higher price? And what if this happened consistently so that the stock market your broker saw and the "true" market—what it was actually possible to buy—were two different stock markets?

This state of affairs is called "front-running": High frequency trade firms pay public and private exchanges for the privilege of seeing their incoming orders. When the high frequency traders saw the order placed on one of the exchanges, they raced to buy all of the stock everywhere else, then offered to sell the stock they'd purchased at a higher price.

In other words, if you know about the orders in advance, you can manipulate the trade to your advantage. That is what high frequency traders do.

Here is an analogy that makes it clear how high frequency trading works: Suppose you and large number of your friends want to buy tickets for a particular concert, so you call the ticket seller. The ticket seller then calls a scalper to let him know that you and your friends want to buy a large number of concert tickets. The scalper orders the tickets at the current price—without paying for them. The scalper then sells the tickets to you at a higher price, pays the ticket seller for the tickets he ordered, and pockets the difference. The scalper never runs the risk of having tickets he can't sell because he has the sellers in hand. He never runs the risk rising ticket prices because he buys them up before anyone knows that demand (and hence, the price) for the tickets is rising.

That is how high-frequency trading works—except that the buying and selling takes place on the order of microseconds. The name of the game is speed-the faster your trading algorithms, the easier it is to exploit that tiny gap between the time an order is placed and when it is filled. That means being faster than the other guys. High frequency traders pay to locate their servers as close to stock exchanges as possible. The only limit is a physical one—the speed at which electronic signals travel through cables. A microsecond advantage can translate into billions of dollars of income annually. So the closer the trader is to the exchange, the greater the speed advantage he enjoys. Which is why high frequency traders pay to install their systems inside the exchanges or as close as they can possible get them.

To put it another way, the market a high-frequency trader sees is not the market the average investor sees: They are privy to stock orders in the split second before the orders are filled, and they use that information to exploit the trade. They also engage in "spoofing": Submitting anonymous bids then withdrawing them in a matter of seconds in order to push a stock price up briefly, get others to buy it, then sell at a higher profit. They pay Wall Street banks for access to their internal "dark pools" so that they can see the stock orders and capitalize on that inside information. In other words, they paid Wall Street banks for the opportunity to exploit their customers.

It may surprise you to find out that "trading ahead of the market" or "front running" is entirely legal.

In fact, in the book Flash Boys by Michael Lewis, financial services executive Brad Katsuyama describes a meeting he had with Securities and Exchange Commission agents to discuss a system he designed to route buy and sell orders so that they arrived at the exchanges at the same time. What took place is truly Kafka-esque: Some SEC staffers argued that what Katsuyama was doing was unfair because it prevented high frequency traders from posting phony bids and offers on the exchanges in order to extract information from the actual investors without running the risk of having to stand by them. It was unfair, they argued, to force these traders to honor their bids and offers. Other SEC staffers took the opposite view, arguing that if these traders don't want to honor their offers, they shouldn't be there at all. Nothing was resolved at the meeting. But Michael Lewis points out that more than 200 SEC staffers since 2007 have left the SEC to work for high-frequency trading firms or firms that lobbied Washington on their behalf.

And it gets worse. Brokers at large investment banks can either go to one of the public exchanges to fill a customer's order (such as the New York Stock Exchange) or they can fill the order within their firm's own internal private trading forum ("dark pool"). h According to Lewis, “Collectively, the banks had managed to move 38 percent of the entire U.S. stock market now traded inside their dark pools…” In other words, the brokers own traders trade against the broker's customers in their own dark pools.

Yes, this is legal. In fact, in the book Flash Boys by Michael Lewis, financial services executive Brad Katsuyama describes a meeting he had with Securities and Exchange Commission agents to discuss a system he designed to route buy and sell orders so that they arrived at the exchanges at the same time. What took place is truly Kafka-esque: Some SEC staffers argued that what Kitayama was doing was unfair because it prevented high frequency traders from posting phony bids and offers on the exchanges in order to extract information from the actual investors without running the risk of having to stand by them. It was unfair, they argued, to force these traders to honor their bids and offers. Other SEC staffers took the opposite view, arguing that if these traders don't want to honor their offers, they shouldn't be there at all. Nothing was resolved at the meeting. But Michael Lewis points out that more than 200 SEC staffers since 2007 have left the SEC to work for high-frequency trading firms or firms that lobbied Washington on their behalf.

As Katsuyama and others have rightly pointed out, these practices—while not illegal—are certainly unethical and just as certainly threaten the stability of the stock market in the long run. As one Goldman Sachs executive, Brian Levine, put it, "Unless there are some changes, there's going to be a massive crash", he said, "a flash crash times ten"…"I think it's a business decision. I also think it's a moral decision." (p. 238)

Restoring Fairness to the Market

So far, there have been two responses to this potentially deadly situation. First, Katsuyama opened his own stock exchange the main purpose of which was to ensure that buy and sell order arrived at the same time. The solution was simple: Just slow down electronic signal transmission by looping cables (sort of like winding up a garden hose) so that they must travel farther to reach their destinations. Slowing the signals down eliminated the advantage of some traders enjoyed by simply being physically closer to the exchange.

The second is that, in response to outrage generated by Lewis' book Flash Boys, the Securities Exchange Commission, the Financial Industry Regulatory Authority (FINRA), the FBI, and even Congress have launched investigations into the practice of high frequency trading. The question is whether they will fully appreciate the necessity of hiring "quants" of their own to investigate high frequency traders' "algobots" and track their activity. I would not bet on a lawyer or a congressman to understand what "quants" do.

Money underlies every aspect of our lives, and whoever controls the flow of money controls the domestic and global economy. And that is how "quants" rule the world.

Copyright Dr. Denise Cummins May 23, 2014

Dr. Cummins is a research psychologist, a Fellow of the Association for Psychological Science, and the author of Good Thinking: Seven Powerful Ideas That Influence the Way We Think.

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