“Author Michael Lewis: US Stock Market Is Rigged” – Bloomberg

Posted on :Mar 31, 2014

Bloomberg

March 31, 2014

The U.S. stock market is a rigged game where high-frequency traders with  advanced computers make tens of billions of dollars by jumping in front of  investors, according to author Michael Lewis, who spent the past year  researching the topic for his new book “Flash Boys.”

While speed traders’ strategies, developed over the past decade with help  from exchanges, are legal, “it’s just nuts” that they’re allowed, Lewis said  during an interview to be televised Sunday on CBS Corp.’s “60 Minutes.” The  tactics are too complicated for individual investors to understand, he said.

“The United States stock market, the most iconic market in global capitalism,  is rigged,” Lewis, whose books “Liar’s Poker” and “The Big Short” highlighted  Wall Street excesses, said during the interview, according to a transcript. The  new book comes out Monday. “It’s crazy that it’s legal for some people to get  advance news on prices and what investors are doing.”

Everyone who owns equities is victimized by the practices, in which the  fastest traders figure out which stocks investors plan to buy, purchase them  first and then sell them back at a higher price, said Lewis, a columnist for  Bloomberg View. To show how lucrative the tactics are, Lewis said a technology  firm spent $300 million to build a line that would shave three milliseconds off  the time it takes to communicate between New Jersey and Chicago, then leased it  out to securities companies for $10 million each.

The author’s comments follow New York Attorney General Eric Schneiderman’s  decision to investigate privileges marketed to professional traders that allow  them to place their computers within feet of exchanges and buy access to faster  data streams. Officials at the U.S. Securities and Exchange Commission and  Commodity Futures Trading Commission have also said market rules may need to be  examined.

                       Industry Obsession

Lewis is adding his voice to a debate that has obsessed the securities  industry for almost a decade while only periodically surfacing in public via  events such as the May 2010 flash crash, in which the Dow Jones Industrial  Average posted an almost 1,000 point loss. Previous books by the one-time  Salomon Brothers Inc. trader have focused attention on everything from mortgage  derivatives to baseball statistics and contributed to the outcry over the events  leading to the 2008 financial crisis.

His latest target, high-frequency trading, comprises a diverse set of  software-driven strategies that have spread from U.S. equity markets to most  developed countries as computer power grew and regulators tried to break the  grip of centralized exchanges. While the tactics vary, they usually employ  super- fast computers to post and cancel orders at rates measured in thousandths  or even millionths of a second to capture price discrepancies on more than 50  public and private venues that make up the American equities market.

                        Dominating Volume

High-frequency traders account for about half of share volume in the U.S., a  statistic that shows their pervasiveness and hints at the obstacles faced by  proposals to rein them in. Exchanges rely on HFTs for profits as well as  liquidity, with electronic market makers all but eliminating the old system of  human floor traders who oversaw the buying and selling of equities. While  critics such as Lewis see a Wall Street plot, proponents say the new system is  faster and cheaper.

In the U.S., the biggest high-speed traders include Virtu Financial Inc.,  which filed in March to sell shares to the public. Bats Global Markets Inc., the  Lenexa, Kansas-based equity exchange that merged with Direct Edge Holdings LLC  this year, was founded by a high-frequency trader.

“We believe Lewis’s book can have a big impact on complex market-structure  issues that have been simmering for years,” Joe Saluzzi, co-head of equity  trading at Themis Trading LLC and a frequent critic of the status quo in  markets, said before the “60 Minutes” interview was broadcast. “Hopefully this  type of publicity will finally force regulators to take action on issues that  they’ve been sitting on for way too long.”

Book’s Hero

One of the heroes of Lewis’s book is Brad Katsuyama, who left Royal Bank of  Canada in 2012 to form a new market, IEX Group Inc., along with other former  traders from the Toronto- based bank. David Einhorn’s Greenlight Capital Inc.  hedge fund invested in the platform, which started trading in October and was  established to minimize the influence of predatory strategies, Goldman Sachs  Group Inc. has endorsed IEX and is the venue’s biggest broker.

IEX was established partly to address concern that technology advances and  fragmentation have made the $22 trillion U.S. equity market too fast and opaque.  The platform, a dark pool with ambitions to officially become an exchange,  imposes a delay of 350 microseconds, or 350 millionths of a second, on orders —  enough to curb the fastest trading firms. IEX aims for greater transparency by  making its trading rules available for public review, unlike some other  electronic venues.

                          Ticket Prices

During his own interview with “60 Minutes,” Katsuyama described how the stock  market rips off investors. While still at Royal Bank, he noticed that prices  seemed to move against him when he was trading.

“The best analogy I think is that your family wants to go to a concert,” he  said. “You go onto StubHub, there’s four tickets all next to each other for 20  bucks each. You put in an order to buy four tickets, 20 bucks each and it says,  ‘You’ve bought two tickets at 20 bucks each.’ And you go back and those same two  seats that are sitting there have now gone up to $25.”

Katsuyama concluded that his intentions became visible on some exchanges  faster than others. The most fleet-footed traders could take advantage of that  by submitting bids and offers on the slower markets.

Lewis said, “I spoke to dozens of investors, big investors, famous investors  who said that, ‘When Brad Katsuyama came into my office and laid out to me how  the market was rigged, my jaw hit the floor. I mean, I knew something was wrong.  I just didn’t know what it was and no one had told us.’”

                      ‘Completely Disagree’

Eric Ryan, a spokesman for the New York Stock Exchange, declined to comment  on Lewis. Rob Madden of Nasdaq OMX Group Inc. didn’t respond to a request for  comment.

“We completely disagree with allegations that the U.S. equity market is  rigged,” Bats President Bill O’Brien said in an e-mail. “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 Schneiderman is examining the sale of products and services that  offer faster access to data and richer information on trades than is normally  available to the public. Wall Street banks and rapid-fire trading firms pay for  these services, providing millions of dollars in quarterly sales to exchanges  and helping ensure their markets are supplied with standing orders to buy and  sell stocks.

                        Threatening Model

Bloomberg LP, the parent of Bloomberg News, provides its clients with access  to some proprietary exchange feeds.

The investigation threatens to disrupt a model that market regulators have  permitted for years as high-speed trading and concerns about its influence have  grown. Trading firms pay to place their systems in the same data centers as the  exchanges, a practice known as co-location that lets them directly plug in their  companies’ servers and shave millionths of a second off transactions.

High-frequency-trader Virtu publicly released its initial public offering  filing in March. The New York-based market maker, which provides quotes in more  than 10,000 securities and contracts on more than 210 venues in 30 countries,  said it had turned a profit every day except one for five years. The company  uses IEX.

                           CFTC Review

Virtu disclosed in the IPO filing that the U.S. Commodity Futures Trading  Commission is looking into its trading from July 2011 to November 2013,  examining its “participation in certain incentive programs offered by exchanges  or venues,” according to the IPO filing. Virtu said it doesn’t believe it broke  any laws or CFTC rules.

Chris Concannon, Virtu’s president and chief operating officer, declined to  comment before the “60 Minutes” broadcast, citing rules that prevent companies  from speaking while planning IPOs.

Share volume totals show the transformation that high- frequency firms have  wrought in American equity markets. While combined trading on the NYSE and  Nasdaq rarely exceeded 2 billion shares in the 1990s, today it is regularly  three times that in the U.S. About 6.05 billion shares changed hands on all U.S.  exchanges in the last session, data compiled by Bloomberg show.

Not everyone says speed trading is unfair.

‘Not Rigged’

“While there are bad actors in every industry, the game is not rigged in the  favor of professional traders who employ HFT to execute their strategies,” Peter  Nabicht, senior adviser to the Modern Markets Initiative trade group and former  chief technology officer at high-frequency-trading firm Allston Trading, wrote  in an e-mail.

“Rather, they work hard to compete with each other to bring liquidity to the  markets, benefiting average investors,” he added. “Continued debate about the  next evolution of market structure is needed and welcome, provided the debate is  based on fact and resulting actions are reasoned, ensuring average investors  continue to benefit from the transparency and efficiency enabled by inevitable  technological advances.”

The practice of selling enhanced access to brokers accelerated as American  exchanges evolved from member-owned firms amid a flurry of regulation and  computer advances in the 1990s. Among other changes, the government-mandated  compression of stock price increments to pennies from eighths and sixteenths of  a dollar, a process known as decimalization, squeezed profits for market makers  and specialists that had overseen stock trades.

Encouraging HFT

Faced with the need to maintain liquidity on electronic platforms where  profits were too fleeting for humans to capture, exchanges encouraged  computerized firms to post orders for investors to trade against. Co-location  and customized data feeds developed alongside the hodgepodge of fees and rebates  that market operators use to keep speed traders coming back.

“Part of what you’re seeing here is people not understanding it, because they  either haven’t taken the time or haven’t dug in,” Larry Leibowitz, the former  chief operating officer of NYSE Euronext, said in a March 25 conference call  with analysts arranged by Sandler O’Neill & Partners LP. “It’s the  responsibility of regulators to show leadership to show, ‘We looked at these  issues, and we think these are fair. These are areas we want to improve and fine  tune.’”

Old Days

Market-maker privileges have always been a hallmark of equity trading,  starting with the sale of seats on the floors of exchanges. LaBranche & Co.,  created in January 1924, went public in August 1999. In papers prepared for its  IPO, LaBranche disclosed that it regularly turned about 71 percent of sales into  profit before paying its managing directors. Earnings before that expense  climbed at least 25 percent every year from 1995 through 1999.

Results like those, as well as concern that NYSE and Nasdaq were too  powerful, helped spur reforms since 2000 such as decimalization and a broader  overhaul known as Regulation NMS that was aimed at lowering barriers to trading.  Through rules mandating that any order for stock be routed to whoever in the  country was transmitting the best offer to buy or sell, regulators hoped  competition among a much larger pool of de facto market makers would lower costs  for investors.

That happened. Buying 1,000 shares of AT&T before 1975 would have cost  $800 in commissions, Charles Schwab, who founded discount brokerage Charles  Schwab Corp., told the U.S. Senate in February 2000. That’s roughly 100 times  more than the fees paid by some retail stock-pickers today.

                           SEC Review

Federal regulators have asked for years whether new restrictions were needed.  In February 2012, Daniel Hawke, the head of the SEC’s market-abuse unit, said  the agency was examining practices such as co-location and rebates that  exchanges pay to spur transactions. Last year, the CFTC announced a review of  speed trading and sought industry input.

SEC Commissioner Daniel Gallagher said on March 28 that individuals are  concerned that high-frequency traders detract from fairness in the  marketplace.

“The problem with high-frequency trading right now is that there’s a  perception that for the little guy, the markets aren’t fair,” Gallagher told  CNBC during an interview. “That perception to me is a reality. It’s something we  need to address.”

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