Flashboys and “Investor” Outrage

Doug Orr, Guest Blogger

In his article “The Big Casino,” in the latest issue of Dollars & Sense magazine, economist Doug Orr notes the recent attention—thanks largely to Michael Lewis’ celebrated book Flash Boys: A Wall Street Revolt—to high-speed stock trading. Lewis tells a story in which the problem goes no deeper than the rigging of the stock-market game to favor some players over others. (It is a measure of the superficiality of Lewis’ analysis that the solution on offer, and the objective of the story’s heroes, is to set up a different kind of casino!) “The problem with the stock market is not just that the casino game has been rigged to favor some gamblers,” Orr argues. “More fundamentally, the problem is the existence of the casino in the first place.”

Gamblers at a blackjack table know they will occasionally lose. But if they see a player who can take his bets off the table if he is losing and can take part of every pot as well, they will be very upset. This is why Michael Lewis’ book Flash Boys: A Wall Street Revolt, which describes how high-frequency traders are able to “frontrun” the market, has raised such a furor in the business press. Gamblers like playing the game, but not if the game is rigged. When they finally find out how it is rigged they will protest loudly.

On April 3, in reaction to the revelations in Flash Boys, brokerage-firm founder Charles R. “Chuck” Schwab issued a statement calling high-speed trading a “growing cancer” that threatens to destroy faith in the fairness of the markets. Schwab pointed out that while the total number of trades stayed relatively flat from 2007 to 2013, the number of trade inquires rose from 50,000 per second to 300,000 per second! He called this “an explosion of head-fake ephemeral orders” designed to “skim pennies off the public markets by the billions.” He claimed that “high-frequency trading isn’t providing more efficient, liquid markets,” but rather it is “picking the pockets of legitimate market participants.” He pointed out that some high-frequency traders claim to be profitable on over 99% of their trading days, a statistical impossibility unless the game is rigged.

High-speed trading is only one of the many forms of front-running. Another can occur in what are called “dark pools.” Dark pools occur when trades are carried out entirely within a single bank, brokerage firm or hedge fund. A bank or brokerage may have a large institutional financial institution, such as a pension fund, that wants to sell a large block of a particular stock. Bidding such a large sale on a public exchange is likely to “move the market,” because the depth of the market will be transparent. If the bank or brokerage can arrange for a trade with a group of other clients that want to buy that particular stock, the buyers and seller can negotiate a price without the public market being aware of the transaction. The bank or brokerage could also decide to buy part of the block using their own proprietary funds. When the transaction is finally recorded, the market may move. It is here that the bank can use the information from the “dark transaction” and use their propriety funds to make a 100% accurate bet on the movement of the price. This is part of the reason the Volker Rule proposes to restrict banks from proprietary trading.

Lewis writes, “The trouble with the stock market—with all of the public and private exchanges—was that they were fantastically gameable, and had been gamed: first by clever guys in small shops, and then by prop[rietary] traders who moved inside the big Wall Street banks.” Both Lewis and Schwab see the game as rigged, but they both still cling to the idea that if it were not rigged, it would efficiently channel capital to productive investment. Given that not a single dollar from any trade on the secondary markets goes into productive investment, this refusal to see the stock market as nothing more than a big casino is incredibly self-serving.

The bottom line is that modern electronic trading does not necessarily make financial markets more efficient or provide increased liquidity. Rather it sets up a situation of “haves” and “have-nots.” The “haves” can use their existing wealth to build high-speed trading systems and other forms of front-running. They will use these systems to strip wealth from the “have-nots.” While this is often a case of the “richest” stealing from the “rich but less rich,” it is also draining wealth from pension funds and defined-contribution savings plans, such as 401(k)s. The ongoing allocation of resources to maintaining an edge in the market drains those resources from more productive uses in the real economy. It also makes the financial markets more unstable.

Charles Schwab suggests that all of these practices should be made illegal. But history teaches us that “entrepreneurs” will always find a way around rules. A better solution would be to make this part of a speculation reduction tax package. Since the average profit from front-running by high-speed traders is less than 0.1%, a tax of 0.1% on every order and cancellation should greatly reduce the practice. Placing a speculation reduction tax of 0.5% on every stock trade, whether it occurs in a public market or in dark pools, would greatly increase the stability and fairness of financial markets.

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