Wall Street Always Pays Itself First

Michael Lewis is right -- equity markets are "rigged" -- but only in the sense that retail investors are at a disadvantage to the bigger players. It has always been thus. 
Beware, retail investor. Photographer: Jin Lee/Bloomberg

The U.S. stock market is rigged. Or so proclaims Michael Lewis in his latest book, "Flash Boys," which digs deep into the arcane world of high-frequency trading. That's quite an incendiary remark even for Lewis, a Bloomberg View columnist and former Salomon Bros. trader whose first book, "Liar's Poker," exposed some of Wall Street's 1980s casino-like excess.

He's right -- equity markets are "rigged," in the sense that retail investors are at a disadvantage to the bigger players. This isn't, however, a recent development.

To understand what's going on, it's important to first understand what high-frequency traders do. Companies such as Virtu Financial Inc. and Getco LLC, for example, obtain proprietary data feeds from the exchanges. (Bloomberg LP, the parent of Bloomberg News, provides clients with access to some exchange data feeds.) The data reveal the buying and selling intentions of mutual funds, hedge funds, insurance companies and the like. This pre-trade order flow contains valuable supply and demand information, which the high-speed outfits use to jump ahead of the actual orders, using sophisticated algorithms. They profit by selling shares to the ever-so-slightly slower players at a markup. All this takes place within microseconds, fractions of the blink of an eye. To boost their advantage, some high-speed traders pay rent to place their computers near the exchanges' servers, thus shaving off millionths of a second per transaction.

In short, high-frequency traders make money by getting information first and acting on it faster. If this sounds unfair, then Michael Lewis has a book he hopes you'll buy. Problem is, equity markets have always had built-in advantages for certain players. Often those advantages are not flaws but design features.

Consider the New York Stock Exchange, where all the action (until recently) centered around floor specialists, the middlemen who manage trading in a handful of stocks. They match bids and offers that arrive electronically, and also conduct live auctions among the floor brokers gathered around their posts. The specialists have an information advantage -- they get to see orders before anyone else does -- and yet they are allowed to trade shares for their own profit as well. It's like being in a card game in which one player can see everyone else's hand.

The NYSE offers advantages to large mutual funds and other institutions, too. For example, they often conduct business using their own floor brokers, who are paid to closely watch the trading of, and sometimes eavesdrop on, rival institutions' floor brokers. Or they can use "upstairs" traders, the trading desks of the big brokerage firms (once located above the NYSE floor), which trade large blocks of shares faster than the specialists can.

The Nasdaq stock market doesn't use specialists (it never had a trading floor) but it does have market makers, or dealers who advertise the prices at which they are willing to buy or sell stocks. They get to see all the orders coming in, and they profit from the spread between the prices they pay to buy shares and the prices at which they sell them. As a result, they know how much demand there is at different prices, and they know the actual prices at which trades were made. Talk about an information advantage!

In the last few decades, the NYSE and Nasdaq trading systems have taken a back seat to other venues. A big reason is that transaction costs -- the amount by which the market price moves against a major buyer or seller after placing an order -- got out of hand. Institutional investors such as mutual funds felt they were being front-run by the middlemen, hedge funds and each other. So they turned to other solutions.

The result has been the rise of private electronic networks, dark pools and now high-frequency trading -- all encouraged or at least condoned by the Securities and Exchange Commission.

In many ways, high-frequency traders are another form of middleman. They get a sneak peek at order flow, and much like a specialist or market-maker, use that information to legally jump ahead. The speed traders, however, are mostly competing against each other. Retail investors fell behind many decades ago and never really had a chance to catch up.

With each new trading development, retail investors remain the last to learn about price movements or large buy and sell orders. They are -- and always will be -- the "dumb money" that the professionals take for granted. Even if Congress outlawed high-frequency trading, retail investors wouldn't get the level playing field Michael Lewis and others seem to think they should have.

To contact the author of this article: Paula Dwyer at pdwyer11@bloomberg.net

To contact the editor responsible for this article: Mark Whitehouse at mwhitehouse1@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.