Walking around on what were perfect fairways at the Masters, a golf tournament in Augusta, Georgia, I learned that beneath the grass everywhere were perforated pipes connected to giant underground electric pumps. The system, which can sometimes be heard thrumming deep underground, sucked rain water down through the turf and left the fairways bone dry within hours after heavy storms. That, of course, got me thinking about the stock market and how so-called High Frequency Traders are using the computer equivalent of these pumps to suck up profits from the mutual fund and pension accounts of millions of Americans.
The new Michael Lewis book, “Flash Boys” spells out in numbing detail how the game is played. It stems from the emergence of new electronic stock markets beyond the familiar New York, American, and NASDAC exchanges. Now, over thirty new computerized exchanges trade stocks in milliseconds and these trades make up the vast majority of all stock trading today. The advantage for those who practice High Frequency Trading is the ability to trade ahead of the major institutions, such as mutual funds, that service the rest of us. Our money managers find that they are frustrated in attempts to buy and sell large blocks of stock cost-effectively because High Frequency Trading contaminates the pricing. It costs our managers more to buy, and they get to sell for less, than would have been the case more than five years ago before this phenomenon reached full flower.
What does it cost us? Well, one hedge fund manager quoted in the book claimed that he was losing 3 percent per year as a consequence. An estimate of what HFT’s make overall is somewhere in the neighborhood of $22 billion per year which would mean about one quarter of one percent of the total $17 trillion in U. S. equity assets. These traders take no risk and, in one publicized case, they make the claim that they never have a day in which they lose money. Meanwhile, nine major too-big-to-fail banks operate highly profitable pools and are the enablers of 70 percent of the high frequency trading.
Michael Lewis is not the first to let us know about this phenomenon. He is just the best at telling a story. Two other books were published in 2012 on the subject: Scott Patterson’s “Dark Pools --- High-Speed Traders … and the Threat to the Global financial System.” Next was Jeff Connaughton who wrote “The Payoff --- Why Wall Street Always Wins.”
Why our elected representatives and regulatory authorities allow this to happen is a question that has been asked repeatedly since about 2009. The answer, as presented in the Lewis book, is that over 200 staffers of the Securities and Exchange Commission since 2007 have left to go to work for High Frequency Trading firms. Go figure. Jeff Connaughton points out that laws were written to allow the practice back in 2007, but that President Clinton vetoed them. Then, Christopher Dodd, a Senator known to support the banking industry, orchestrated a vote that overrode the President’s veto, so here we are --- with a byzantine system that could collapse the global banking system. It’s as if we hadn’t learned anything from 2007.
The cavalry coming to the rescue consists of an unlikely success story. Some relatively young, very bright guys following the dictates of conscience figured out how to run a dark pool which makes high frequency trading impossible. Their first big customer turned out to be Goldman Sachs. Goldman was motivated by the fact that its own trading system was woefully behind those of the other big banks. While they had bought Hull Trading 15 years ago and were one of the earliest adopters of electronic trading, they were stuck with what had now become the demolition derby car of the industry, held together with wire and duct tape. They decided to get on the right side of history and support a system that could not be abused.
It remains to be seen how this small step for mankind will play out. The financial services industry has a long history of being reluctant to cannibalize existing business models. Nobody, for example, has followed the lead of the world’s largest mutual fund organization which set itself up as a low-priced cooperative owned by its investors. But unlike tech, the financial services industry has long since proven that you can fool a lot of the people a lot of the time. In the process, the disappearing money from everyone’s accounts makes what Ross Perot would call, “that great sucking sound” like the fairways underneath Augusta National Golf Club.
Here in the trenches where we all hunker down with our money, the closest thing to an antidote is to consider index funds that trade rarely because turnover is so minimal. Assets bought and held never become prey of the High Frequency Trader crowd.