Thanks to a new book, Flash Boys, by Michael Lewis and an exposé on 60 Minutes, the investing public is now much more aware of an ongoing scheme that affects hundreds, if not thousands, of transactions on the stock exchange a day. I watched the 60 Minutes show and to say the scheme is complicated is an understatement, to say the least. As an example, say an investment management company, company A, purchases large numbers of stocks at a time on behalf of the funds it manages. That purchase order is transmitted along fiber optic cables from company A’s computers, along a circuitous route, until it reaches the exchange and the transaction can be finalized.
Along the way, the purchase passes through a hub of sorts. At that point, high-frequency trading companies (also called high-speed traders), like company “B,” that have no other purpose than to monitor the system for large purchases, essentially jump to the front of the line. These companies become aware of the pending purchase made by Company A once the transaction begins to process, but before it is finalized by the exchange. Awareness alone, however, does them no good.
High-frequency trading companies operate in one of two ways. Some paid hundreds of millions of dollars to lay their own fiber optic cables that run in a straight line, rather than a circuitous route, from the hub to the exchange. Others paid premiums to have their servers placed directly next to the exchange servers. Because of the shorter routes (either by physical proximity or by strategic placement of fiber-optic cables), company B’s purchase beats company A’s to the exchange by milliseconds.
Once Company B’s purchase is finalized, the demand for that stock has increased, so the cost automatically increases. Company B then immediately sells the stocks to Company A, fulfilling Company A’s earlier placed, but later arrived purchase. Even if that increase in price is nominal, $0.01 for example, when that one penny is added on to each share and is attached to millions of purchases a day, Company B makes a sizeable profit just by being faster or closer.
This scheme all began once the Securities and Exchange Commission (SEC) allowed stock exchanges to share all of the unexecuted, incoming orders with traders. Tradebot, one of the biggest high-frequency companies, said a few years ago that the company had “not had a losing day of trading in four years.” Yet, the company’s average holding period for stocks is a mere 11 seconds. Logically, that seems impossible. After all, it isn’t called “playing the market” without reason – it is a statistical certainty that a percentage of trades will be losers. High-frequency trading companies, like Tradebot, succeed because, in reality, they are not actually trading. They are “skimming” by beating would-be stock purchasers to the exchange, driving up the cost, and then re-selling those same stocks to the very people they just jumped in line.
High-frequency traders account for approximately half of share volume in the U.S., a statistic that shows their pervasiveness and also hints at the obstacles faced by proposals to rein them in. Of course, the high-frequency traders disagree that their actions are anything but legitimate. Bats President Bill O’Brien said in an e-mail:
We completely disagree with allegations that the U.S. equity market is rigged. While we should never stop trying to improve our market structure, it is unfair and irresponsible to accuse people simply because they use technology and enhance competition. This has helped make our market the most competitive and liquid in the world, greatly benefiting individual investors.
New York’s Attorney General, Eric Schneiderman, disagrees and he is investigating these processes. Officials at the U.S. Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) have said market rules may need to be examined. An SEC commissioner, Daniel Gallagher, agrees that the perception of unfairness in the market needs to be addressed. In fact, the SEC announced on April 1 that it is investigating the high-frequency trading companies to determine if they are engaged in unlawful trading practices.
The Federal Bureau of Investigation (FBI) has also announced that it is investigating whether high-frequency traders are engaging in insider trading by taking advantage of market information that is not available to other investors. The difficulty for the FBI will be proving intent and that’s because the trades at issue are initiated by computers.
Currently, high-frequency traders’ profits are gained by increasing the costs to nearly every other purchaser on the market by falsely flooding the market with fake demand. Hopefully there is a solution on the horizon. For now, unfortunately, high-frequency traders have a legal means of taking millions of dollars from legitimate investors by doing nothing other than being faster or closer, through no skill of their own – just proximity and shorter cables. If you need additional information on this subject, contact Rebecca Gilliland, a lawyer in our firm’s Consumer Fraud Section, at 800-898-2034 or by email at Rebecca.Gilliland@beasleyallen.com.
Sources: Bloomberg View and Wall Street Journal
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