Is the stock market rigged?

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Best-selling author Michael Lewis certainly thinks so. In his latest book Flash Boys, he examines the phenomenon of high-frequency trading, and concludes that a few companies are making fortunes at the expense of other investors. “The United States stock market, the most iconic market in global capitalism, is rigged,” he told CBS News. But what exactly is high-frequency trading, and how does it affect individual investors like you and me?

The Need for Speed

Forget those TV images of traders shouting orders across the floor of the stock exchange. These days, the vast majority of trading happens electronically, and it’s not the person with the loudest voice who gets the best price, but the company with the fastest cables. If you place a trade to buy Microsoft shares, for example, Lewis says that a high-speed trader’s computer system could detect your trade and jump the queue, buying the Microsoft shares you’d planned to buy and then selling them to you – for a slightly higher price. All of this happens in tiny fractions of a second, and is completely automated. Speed is so vital that companies are investing millions in the latest technology. One company laid a high-speed fiber optic cable from the futures market in Chicago to the exchanges in New Jersey, spending $300 million just to shave three milliseconds off the transaction time.

How It Affects Investors

The bottom line for investors is that you may not always be getting the best price. On each trade, the difference is usually tiny, but over time it adds up. Lewis admits it’s tough to pin down the figures, but estimates that the “predatory strategies” he investigated are worth around $15 billion. Even without predators, these large amounts of automated trading can make the markets unstable and subject to wild swings, as we saw with the Flash Crash of 2010. And some traders are also taking advantage of getting economic data and other announcements fractionally ahead of others. But that doesn’t mean you should stop investing in stocks altogether. While Flash Boys pits good guys against bad guys, the reality is not quite so simple. For one thing, some argue that the large institutional investors are the ones losing out to high-frequency traders. Retail investors making small trades go through a different process, and are more likely to get the best available price. For another thing, the amounts shaved off on each trade are tiny, and any loss will probably be dwarfed by other things like the fees you pay to brokers, fund managers and others. And there’s also an argument that high-frequency trading provides liquidity in the market. Whenever you trade, there’s a “spread” between the bid and offer prices. The more activity there is, the lower the spread – good news for investors. So by all means be angry about the practices that are giving high-frequency traders an advantage — but many experts say you shouldn’t let it put you off investing altogether.

What’s Happening Now?

In an attempt to avoid being outrun by the speedsters, some large investors are trading in private systems known as “dark pools.” The idea is to let investors make large trades without signaling their intentions to the broader market. A pension fund manager, for example, might want to sell off a million shares in a company. On the public stock exchange, such a large sale would attract attention and the price could go down before the trade is completed. In a dark pool, it remains private, probably resulting in a better price. There are now dozens of dark pools – some owned by big broker-dealers, and others set up by independent companies like IEX. Shares changing hands in private venues now account for 40% of all trades. The Securities & Exchange Commission is worried about so many transactions happening privately, and is investigating some large dark pools. “Transparency has long been a hallmark of the U.S. securities markets, and I am concerned by the lack of it in these dark venues,” said SEC Chair Mary-Jo White. Meanwhile, the FBI is investigating whether the actions of high-speed trading firms amount to insider trading, and the New York Attorney General also launched an investigation. With all the outrage around high-frequency trading, you can expect some rule changes, as well as some punishments for the worst offenders. But it’s unlikely that automated trading will stop altogether. From the time the U.S. stock exchanges went electronic about 15 years ago, people have been exploring ways to use technology to gain an advantage. Expect that to continue, while regulators do their best to keep the playing field level amid constant technological progress.

What do you think?

Is the stock market rigged? Do high-speed traders do more harm than good? Should the government get involved? Let us know in the comments.

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