Last week's New York Times article on high frequency trading set off a firestorm that engulfed the financial news networks, the blogosphere and even pulled Senator Chuck Schumer (D-NY) into the debate who said: "The hallmark of our markets are that they are open and above board and the little guy has as much of a chance as the big guy…This takes a dagger to the heart of that concept." While I agree with Schumer emphatically, there's a lot of misinformation here. I can't remember the last time I've seen so much hoopla and anger on a topic very few really understand. Sure, there's plenty to be angry about, but not necessarily for the reasons everyone thinks.First off, let's differentiate between flash orders and high frequency trading. The two seem to have been mixed up in the press, but they're separate issues.High Frequency TradingHigh Frequency Trading (HFT) is different from flash orders, though the two can be intermingled. Basically, high frequency traders buy enormously powerful computers to crunch sophisticated algorithms trying to beat the market. They are looking to make a tiny profit off of an enormous number of trades. And when you add it up all those tiny profits, the numbers are astounding. According to the Tabb Group, they generated about $21 billion in profits last year alone.Think about that. $21 Billion in a down market! And to be clear, that money comes out of someone's pocket. Mutual funds, pension funds and individual traders are all affected. And some of it may have come out of your pocket. Let's do some simple math. If there are 50MM investing households in the US (including 401k and pension holders), then $21B / $50M = $420. So on average, these guys outsmarted each investing household by $420. OK, so not everyone was affected, not all the money was made in the US and not all of it was at the expense of individual investors. All true. But wow. Those are staggering numbers.The thing is, as long as they are trading off the same information as we are, I'm not sure I can find anything wrong with it. They’re just leveraging technology and some of the smartest minds in the world to figure out how to beat the market. As many of you do.But, and this is a huge BUT, if they are using flash orders to gain an information advantage, then they would have an enormous advantage. And that I take issue with.Flash OrdersFlash orders are a little known, but egregiously unfair loophole in current SEC regulations that allow exchange and ECN members to see trades before the general market does. It works something like this:- You submit an order to a market center like Direct Edge.
- Traders on Direct Edge who pay extra fees get to see your order before it's routed to other exchanges for execution at the current best price in the market. They can fill your order at the NBBO or do nothing.
- During this time period, these traders have information that the rest of the market doesn't have about demand for the stock
- Also during this time period, your order is held up, and the market could be running away from you.
Why do I think this is wrong? First off, these traders get access to trade data that retail investors don't have. That's called unfair information asymmetry. How can a retail investor compete with someone who has data before you do?Secondly, there is a big risk that one of these traders could front-run you. That's not only unethical but also illegal. But as the Bernie Madoffs of the world have shown time and again, WallStreet isn't the most ethical or law abiding bunch in the world. The temptations to make millions – or billions – of risk free money is just too great. I'll bet my house that there are traders out there using this information to front-run you as we speak.Thirdly, the information imbalance creates what's called a "tiered market." That means that the NBBO may not be the best price in the market and traders who pay extra money may be able to trade at better prices that you and I receive.Finally, YOUR ORDER IS DELAYED! It's sitting there waiting to be routed to another exchange while some trader decides whether or not to fill it.Is this wrong? You bet. Should you be angry? Absolutely!For the reasons I laid out, I believe flash trading gives an unfair advantage to big banks and investment banks trading on them. In 1998 the SEC authorized electronic exchanges to level the playing field so anyone with, as the NY Times put it, "with a desktop computer and a fresh idea" could compete in the marketplace. Flash orders are a huge step backwards in the objective.Don't get me wrong, I'm all for technology. Zecco is part of the technological revolution. And I'm all for innovation. But I strongly believe that big or small, everyone should get a fair shake. Everyone should get the same information at the same time. Zecco is all about empowering the individual investor and flash trading flies in the face of that. Our community, our trading platform, our education (Zecco Zirens) center, our competitive pricing is all meant to level the playing field and allow anyone, anywhere with a laptop to trade stocks. This practice undermines the fundamental fairness of the stock market. As Andrew M. Brooks said in a recent NY Times article on the topic: "You want to encourage innovation, and you want to reward companies that have invested in technology and ideas that make the markets more efficient… (But) people want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity." I believe flash orders should – and need to be – banned. Period. The temptation for enormous profits at the little guys expense are just too great. This is a fundamental issue of fairness. It's David vs. Goliath. Us vs. them.
Take Action Now!If you disagree with me, then I'd love to hear your thoughts right here! If you agree with me, join me in taking action. I'll be speaking with the media in the coming weeks to help shed some light on the issues. For your part, you can:
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