Dave Sather's Money Matters: Are the markets rigged?

By Dave Sather
May 20, 2014 at 12:20 a.m.

By Dave Sather

No sooner had "Flash Boys" author Michael Lewis finished speaking, an email from my friend Vic hit my inbox.

"Did you see Michael Lewis on '60 Minutes'? Do you really think the financial markets are rigged?" Vic asked.

I had seen the interview and had to admit that Lewis got my attention. Furthermore, I had to believe he had the attention of investors worldwide.

Lewis is the author of many great books: "The Blindside," "Liars Poker" and "Money Ball," to name a few. However, "Flash Boys" has elicited a variety of responses from people in the financial markets and those trying to get a fair deal when investing.

The author began the interview by stating that the financial markets are rigged and then explained that traders with very high-powered and very fast computers are able to game the system.

These people are known as high-frequency traders, or HFTs, and they use super computers to jump in front of other people's stock trades to sell the shares they are looking for at fractionally higher prices. The high-frequency traders repeat this process millions of times a day.

This process requires collusion from the exchanges themselves. In a fair market, people wanting to buy or sell a security get in line. Everyone who wants to buy "at the market" or a specific price should stand in line in sequence based upon when they placed their order.

However, the stock exchanges themselves have cut side deals with the high-frequency traders to allow them to jump in front of other people's trades after the high-frequency traders have seen the trades that people behind them want to place.

In the example that was given, it is like going to Stub Hub to buy four tickets for a concert. After seeing and confirming that the tickets you want are available for $25 each, you are told only two were available at $25, and the other two will cost you a few dollars more.

This is a high-tech version of "front running" - and yes, front running is illegal. However, because this form of technological manipulation is so new, it is not technically illegal.

A logical question is "Why would the exchanges allow this to happen?"

Twenty years ago, there were about four main stock exchanges manned by inefficient human beings interacting with other human beings to get trading done.

As with everything else in society, technology has made its impact. What is not intuitive is that with the implementation of efficient technology, the need for all the stock exchanges has not gone down. In fact, it has increased to 13.

The 13 exchanges are enablers. They want increased volume since it drives up commissions. And since high-frequency traders comprise about 50 percent of daily stock trading volume, the stock exchanges really like the high-frequency traders.

So back to the original question: Are the markets rigged? This statement may be a bit of an exaggeration by Lewis, but functionally, he is correct.

The stock exchanges need to get rid of "pay for placement," as it clearly is unethical. This should remind investors that if you want to identify conflicts of interest, follow the money.

With exchanges being operated as for-profit entities, the goal of maximizing profit is overtly circumventing any fiduciary obligation to the other people trading on the exchanges.

Although the cost to the average person on a trade may be a few pennies or even fractions of a penny, it is still unfair. Given the volume of trading done each day, it is very lucrative for the high frequency traders' firms.

For the average person, the high frequency traders issues should not be a deterrent to a logical and long-term investment plan. However, it should remind people that the more they trade, the more trading costs increase. The best results still come from being a consistent and patient investor during very long periods of time.

So is high-frequency trading wrong? Yes.

Does it stop me from wanting to invest? No. It just makes me want to watch my pennies even closer.

Dave Sather is a Victoria certified financial planner and owner of Sather Financial Group. His column, Money Matters, publishes every other week.



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