My favorite author, Michael Lewis, appeared on 60 Minutes last Sunday and started out by saying, ‘The stock market is rigged. The United States stock market, the most iconic market in global capitalism, is rigged.’
A few second later, when anchor Steve Kroft asked who the victims were, Lewis said, ‘Everybody who has an investment in the stock market.’
Wow – that’s scary!
Thankfully, his comments aren’t really true. It’s a gross – no, grotesque – over-generalization designed to hype and sell Lewis’ new book, Flash Boys: A Wall Street Revolt.
And, it appears to be working: when I bought it last night on the Kindle store at Amazon, it said it was already a #1 Best Seller. Since his appearance on 60 Minutes, I’ve seen him on CNBC and heard him on NPR.
Based on the interviews that I have seen and heard (no, I haven’t had time to read it), his book is about how some people use what a strategy called high frequency trading (HFT) to gain advantage over other investors.
For example, let’s assume that a mutual fund wants to buy 10,000 shares of stock ABC and it sees the market trading for $100 per share.
1. The mutual fund enters their order into a trading terminal somewhere and the order is sent to ‘the market,’ which most people don’t realize is actually 13 different exchanges.
2. Because the HFT firms have better computer hardware and faster software, they can often see the order before the many of the other market participants.
3. The HFT firm starts buying stock aggressively before the order from the mutual fund is even received by the rest of the market and their buy activity raises the price until the price rises to $100.01, for example.
4. The mutual fund now buys the stock at $100.01, at which point the HFT firm starts liquidating their position at the higher price earning 0.01 per share.
5. All of this takes place in well under a second. Trading is now measured in picoseconds, which is one-millionth of a second
6. The HFT traders skimmed 0.01 percent on the trade and the mutual fund and its clients had to pay more than they originally intended.
Of course, my example is an over simplification, but this is the idea and there is nothing new about this. I heard Lewis claim today that it started in 2008, but it really started in the 1990s when electronic exchanges saw what they thought were unfair monopolies held by the exchanges like the NYSE, AMEX and NASDAQ.
In those days, the mutual fund might have gotten $100 (or they might not have), but in my example, I only listed the price to buy the stock. When a market maker quotes a stock, they offer a buy and sell price, known as a bid and offer. In the example above, maybe the buy price was 100, but the sell price was 99.75.
One of the major outcomes of HFT is that the bid/offer spread, or difference between the two prices has collapsed and it is much cheaper to buy and sell stocks today than it was 10-15 years ago. And, it’s not like the market makers in the old days didn’t pump up prices when they saw big orders coming in, there is nothing new about that either.
I don’t have a stake in HFT and I can see why people don’t like what you can argue is a skimming operation. That said, what I do like about HFT is that they keep prices really competitive and the cost of their skimming seems worth the value of the overall more competitive pricing to me.
Lewis said that the HFT traders might make tens of billions of dollars, and they might, but he was quick to point out that no one knows. Even if that’s true, the US stock market is worth $16 trillion market.
If the skimming operations were truly substantial, you would see a performance of big funds. Let’s look at the largest stock mutual fund in the US, the Vanguard Total Stock Market Index fund (VTSAX). Over the last 10 years, the fund has earned 8.05 percent. The fund’s benchmark, which incurs no trading costs and is hypothetical, gained 8.05 percent.
In a perfect world, you would expect a fund to earn the same return as the benchmark minus Vanguard’s fee, which is now 0.05 percent (and was higher in years past). Despite the HFT traders, Vanguard earned returns above the benchmark to cover the management cost. If HFT skimmers were so good, this wouldn’t be possible for such a large fund.
A few years back, I visited Vanguard’s HQ and went into the equity trading room. It was about the size of our office and there were 25-35 traders in the room. Knowing that Vanguard is the second largest asset manager in the world and seeing only 35 people or so trading all of their stocks, I joked to the head trader that if I wanted to see all of the action, we had to go see the server farm. He smiled and said I was dead on.
Markets would not be efficient today without computerization. I’m not saying that I love HFT trading, I don’t, and there are problems with computerization like the 2010 Flash Crash and many smaller glitches that have been less reported since then.
But to say that the market is rigged? Shame on you, Michael Lewis. You can sell plenty of books without such misleading hyperbole.