Beware – Predatory Trading Practices

“Multiply it by infinity, and take it to the depth of forever, and you will still have barely a glimpse of what I am talking about.”— Joe Black in Meet Joe Black

After watching some great basketball Sunday afternoon, I watched Michael Lewis interviewed on 60 Minutes to talk about his new book, Flash Boys, which is a scathing critique of the current structure of the U.S. equity markets and the predatory practices of some high-speed trading firms. I haven’t read the book yet, but I am going to get it.

high-frequency-trading-v2For those unfamiliar, speed trading or high-frequency trading involves trading firms using algorithms and powerful computers to gather market information and react to it faster than those with less sophisticated systems. Basically the speed trader’s computers are able to see market information (stock trading orders) milliseconds or fractions of milliseconds ahead of investors (retail investors or large investors such as mutual funds) at the market center where the investor’s order will ultimately be executed. This gives the speed trader the chance to trade ahead of the investor’s order and beat the investor to the best prices and fill the order with shares the speed trader bought or sold milliseconds earlier.

The speed traders might make a profit of a penny or so a share, but they repeat the process thousands and thousands of times a day. So why is this a big deal? To paraphrase the Joe Black quote: Multiply the penny by the average daily volume of U.S. exchanges (4.5 billion shares), take it to the number of trading days a year (250), and you will have a glimpse of some pretty big money. 4.5 billion *250*.01=11.25 billion. Now deduct that from your future as these costs are a direct drag of the performance or your mutual fund, pension, or 401k, figure in the years you have until retirement and multiply by the number of retirees and other investors.

That is a big tax that the vast majority of investors are paying to a handful of trading firms. Stock exchanges and service providers can make a bunch of money while adding no real value to anything other than their own checkbook. These practices are also likely to exacerbate or even cause market dislocations such as the flash crash. Speed trading strategies appear to be momentum based so they increase the speed and direction of individual stocks and the market’s movement. That may be ok in a rising market where there will always be willing sellers at a price, but in a down market when people are afraid to buy, things could get out of hand quickly and we could see systemic risk.

Yet, the solutions are likely to be pretty simple. Exchanges can be mandated to slow things down a bit. Restrict the practice of co-locating servers at the exchange to give preferred access to certain market participants. Most importantly, eliminate the maker-taker practice of exchanged paying rebates for certain orders and charging for others.

How do you deal with this issue? Write to your congressman. Jeb Hensarling from Texas is chairman of the House Financial Services Committee. If you have an account at a broker dealer, ask the broker dealer’s compliance department if they take efforts to protect your orders from predatory trading practices via their order routing table.

JamesMathisJames Mathis, managing partner of Echelon Investment Management, believes in enriching his clients’ lives by identifying, preserving and achieving their goals. Echelon partners with clients through every leg of their race ~ asset management, investment advice and retirement planning. Contact him at james.mathis@echelonim.com.

Disclaimers: The ideas presented here are for illustrative purposes only. This does not reflect the performance of any specific investment. It should not be assumed that past performance in any way relates to future results. The information herein has been derived from sources believed to be reliable, but this is not a guarantee as to the accuracy and does not purport to be a complete analysis of the security, company or industry involved. An investor should consider, before investing, whether the investor’s or designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s 529 college savings plan. 529 plans are subject to enrollment, maintenance, administrative and management fees and expenses. Non-qualified withdrawals are subject to federal and state income tax and a 10% penalty. Please consult with your financial advisor and tax advisor to determine the strategy that best suits your individual needs.

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