I just finished reading the book Flash Boys by Michael Lewis (author of Moneyball and the Big Short). I highly recommend it to economists as a quick read (270 pages) in accessible prose. Or anyone.
Every economist should be aware of the grossly unfair trading practices that the SEC and NASDAQ have allowed to dominate virtually all stock trades. Lewis documents a large number of explicit rip off techniques from High Frequency Traders (HFT) (which include most of the major money managers) that affect every mutual fund, stock broker and stock trade conducted in the world. While true that HFT create liquidity in the market so that traders can instantly sell whatever stocks at “the market price” in whatever quantities, they do this at the cost of a significant tax on all such transactions and result in billions of dollars of revenue for the HFT companies. Basically, the HFT can influence the market price. This is done in plain sight (the title of chapter 1), not hidden in the form of impenetrable documents such as the the unsecured and overrated mortgage securities.
Since many of you won’t read the book, here is a flavor in my own words.
Your pension fund ABC, which manages a few billions of dollars of stocks, is constantly buying and selling stocks on your behalf to maintain its portfolio. Say it wants to buy 10,000 shares of Microsoft “at the current price” which is $41.90 (the most recently traded price right now on 6/30/2014). The official NASDAQ ticker price shows more than 10,000 shares are offered at $41.90. But as soon as ABC’s bid to buy “at market” is executed, essentially all of those available shares are purchased by HFT within a few microseconds (i.e., a few millions of a second) BEFORE ABC’s purchase, thereby bidding up the price. It could be a penny or it could be much much more, depending on how volatile the stock price is. Today, Microsoft has already varied by .82%, so the variation WITHIN A FEW MICROSECONDS can easily be that amount and you would not even know. Your price at the end of the day would be within the low and high for the day. ABC pays say $41.95, and the HFTs pocket the extra five cents per share on the trade since they were able to purchase at $41.90 before selling it back to you a few microseconds later at $41.95.
You think that it doesn’t matter much because it was only a few pennies on the transaction, and you hold onto your assets for years. But your pension fund is constantly buying and selling as more funds are added, taken out, or market shares of different stocks change. All of these transactions are “taxed” by the HFT firms who buy at below your bid price and then sell the stock to ABC at NO RISK. According to the book, the best HFT firms have traded for years and never had a losing day, since they only bet on sure things.
Here is a second example. You may think there is only one market for each stock, but actually there are more than a dozen different prices since a majority of all trades happen in “dark pools” which are private exchanges organized by the large money managers. The official offer price may appear to be $10.05 but you don’t know that some of these dark pools have offer to sell prices of as little as $10.00. What the market is supposed to do is that if you bid “at market” then you get the lowest value price, which would be $10. What actually happens is that the HFT firms turn this into two transactions, buying at $10.00 and selling to you at $10.05. Again, it doesn’t sound like much until you realize how many millions of transactions there are.
What I found particularly unfair is that the SEC has allowed all kinds of sleazy types of stock sales practices, involving small lot transactions, and bids for shares at prices that need not be honored. This makes it very low cost/low risk for the HFT to figure out who is buying or selling, and take advantage of it.
There is a new exchange called IEX that is trying to become a fair exchange, with some success, but it is getting major push back from the big players. Read more here. http://en.wikipedia.org/wiki/IEX