There was a great piece on 60 minutes last night with Michael Lewis about the financial markets. It is well worth the 14 minutes to watch it and you can see it here: http://www.theblaze.com/stories/2014/03/31/authors-jarring-claim-the-stock-market-is-rigged/.
The topic was about how high frequency equity trading was destroying the financial markets. The solution to solve the problem, as outlined in the interview, is fascinating…creating a platform were people can trust to trade.
Although as we sit here in 2014 the markets are at an all time high, confidence in the financial institutions is at an all time low. Stock ownership has declined dramatically and given that we live in a capitalistic society this should shock many people. The underpinnings of what makes our society tick… free enterprise, risk taking, entrepreneurship… are being taken advantage of and corrupted by the financial marketplace; these risk takers are shunning the market where capital is being allocated.
Over the last 20 years or so stock exchanges have traded humans for machines. I would venture to say that over 90% of all stock exchanges are now electronic. So, now, when you place an order to purchase a stock that order is being handled by a computer not a person.
As this transformation has taken place, pure computer power and the speed of the fiber network has taken precedent over the ability to allocate capital efficiently. High frequency traders over the last 5 years have built these highly complex algorithms to trade and can now execute trades in milliseconds for fractions of a penny. So by the time “Joe Investor” can execute a trade, the high frequency trader can buy and sell that same stock to “Joe Investor” at a slightly higher price and make money off of his order.
Here is an example in practical terms: Say that you wanted to go to the Dolphins game in Florida and saw 4 tickets on stub hub for $20 each each. You decided to buy the 4 tickets but were only successful at buying 2 tickets at $20.00 each. The remaining two tickets, those same additional 2 tickets that you tried to buy minutes before, are now trading at $25.00 each. Why? Because the system recognized your order and filled only 1/2. Then, it raised the price on the other 2 tickets. Since you really need the 2 extra tickets, you buy the last 2 tickets for $10.00 more per ticket.
This example is the same thing that’s happening on Wall Street. High frequency traders can see your order before it gets executed. Then they buy that same stock and sell it back to you for a slightly higher price. The practice is called “front running.” Normally front running is illegal. However, on Wall Street, the way that high frequency traders are doing it…its legal.
A trader from Royal Bank of Canada spent the last 5 years uncovering the problem, detailing it and alerting investors to the pitfall. He subsequently started a new exchange, which brilliantly circumvents the high frequency trader’s edge by way of new software and complicated data routing. With his new exchange, people can trade stocks without the impact of high frequency traders there to rip them off. So far business has been good.
When asked why his business is doing so well he said “trust.” Really that is all that he’s selling. People trade on his system because they know that aren’t going to be ripped off. What a beautiful way to run a business. Do what you say you are going to do and people will come.