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Introduction to Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio

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In this introduction to their book, Joseph C. Saluzzi and Sal L. Arnuk question the roles of stock exchanges and HFT firms, the value they are adding, and the damage they are doing.
This chapter is from the book


The stock market has devolved. Make no mistake, it is broken.

Its primary purpose had always been to facilitate capital formation. Companies that needed funds have always looked to the equity markets to issue stock. The funds they raise via an initial public offering, or IPO, are put to work to generate earnings. The increased earnings drive the share price of their stocks higher, and investors and savers accumulate wealth. That increased wealth, in addition to their wages, drives consumers to spend and buy. And that spending and buying in turn drives demand for corporate goods and services, which in turn drives additional corporate profits, and the cycle continues.

The stock market is the mechanism where IPOs trade among secondary investors and traders. If the secondary market is liquid with lots of transactions and trading, then investors feel confident that they can take a risk and buy shares in a company because they could easily exit their investments, should they want.

This linkage has always been crucial to our nation’s greatness and is why America has always been held up as the beacon of capitalism worldwide.

Sadly, today, the primary purpose of the stock market is not capital formation. Investors are an afterthought. The primary purpose of the stock exchanges has devolved to catering to a class of highly profitable market participants called high frequency traders, or HFTs, who are interested only in hyper-short term trading, investors be damned. The stock exchanges give these HFTs perks and advantages to help them be as profitable as possible, even if doing so adversely affects you, the investors, because HFT firms are the exchanges’ biggest customers.

These HFTs use high-powered computers to automatically and algorithmically trade in and out of securities in speeds measured in microseconds (millionths of a second). Although there are few HFTs relative to the number of investors in the marketplace, the following is generally estimated in the industry:

  • HFTs account for 50–75% of the volume traded on the exchanges each day and a substantial portion of the stock exchanges’ profits.
  • While smaller HFTs churn hundreds of millions of shares per day, a few of the larger HFTs each account for more than 10% of any given day’s trading volume.
  • HFTs earn anywhere from $8 billion to as much as $21 billion a year that comes at the expense of long-term investors—you and the institutional investors that manage money on behalf of you.

These HFTs are always hungry for situations for their algorithms to arbitrage. They are hungry, just like Seymour, the man-eating plant from Little Shop of Horrors. And stock exchanges, brokerage firms, technology providers, and consultants spend every waking moment figuring out how they can help their largest customers make more money—new ways to feed Seymour.

When you think about the stocks in your 401k plans, how do you imagine that they trade today? What images come to your mind? Do you think of bustling trading floors in a metropolitan city money center, with humans hustling about screaming, signaling, gesturing, hustling, and interacting? Do you think of Eddie Murphy and Dan Akroid in the climactic final exchange scene in the film, Trading Places? Do you think of the movie Wall Street? Do you think of Maria Bartiromo reporting from the floor of the NYSE amid a sea of mostly male blue coats, trading on behalf of mutual funds, traders, and investors?

Or, do you realize that today the floor of the NYSE is really a prop for television, and that all the majority of trading is done and housed in a suburban warehouse in New Jersey, housing billions of dollars worth of technology and servers owned or leased to HFT firms?

Our point is obviously that the markets have changed drastically in the past decade, and not all the stakeholders have realized this or the implications of those changes.

Our brokerage firm, Themis Trading, has spent the past decade navigating the equity trading landscaping on behalf of our clients, who are long-term institutional investors. We have accumulated in-the-trenches expertise trading stocks in dozens of exchanges and alternative trading systems. We have experience trading with multitudes of technologies. Prior to our careers at Themis, we spent the better part of a decade as sales-traders at the world’s first premier electronic brokerage firm, Instinet, and we spent years before that working at Morgan Stanley in the late 1980s. We have learned to adapt to the ever-changing equity trading landscape. Our front row seats and participation in the markets, throughout the many structural and technological changes that they have undergone, have given us our most important asset: perspective. We have seen the good and bad parts of our market structure in the 1990s and the 2000s, as well as today. We know what works, what doesn’t, and what is problematic—and why.

While trading equities for clients, we have uncovered many unfair practices and outright shenanigans. We have spent a significant amount of energy and time raising these issues to our industry. We have participated in conference panels, appeared on CNBC, Bloomberg TV, and even 60 Minutes. We have given testimony to our regulators—the Securities and Exchange Commission and Commodity Futures Trading Commission. And we have actively blogged our opinions and findings on our firm’s website. Initially, our voice was a small and lonely one. Over the past several years, however, we believe we have made great strides in broadening the discussion about our market structure’s conflicts of interests, and about high frequency trading.

We question the roles of stock exchanges and HFT firms, the value they are adding, and the damage they are doing. It is common to hear in the media how HFT has reduced costs for investors by lowering commissions and narrowing the spread between the prices investors can buy and sell stocks. We see it differently. Although spreads may be narrower in perhaps 5% of the most actively traded names, they are wider in the other 95% of the market. So while our current markets have solved the “problem” of how investors can trade the top 100 companies for a spread measured in pennies, with little or no commission, they have created many other problems, such as extreme volatility and lack of support for small and midcap emerging companies.

Why did we write this book? The discussion and debate around the workings of our capital raising superhighway needs to be had by the much larger and more mainstream stakeholders: investors. For too long, the HFT and market structure debates have been monopolized by a small group of industry insiders, regulators, and group-thinkers. In the process, our markets have morphed into an insanely complex web of conflicted stock exchanges, dark pools, alternative trading systems (ATSs), and liquidity providers. We want to call attention to these conflicts and issues more broadly. We want you to understand how our markets actually work and why they morphed the way they have. It was no accident.

Perhaps you are reading this book because you have heard about high frequency trading on the evening news or from our appearance on 60 Minutes and are curious about all the buzz.

Perhaps you are reading it because you have noticed high frequency trading as a term associated with volatility, and the way the stock market has moved the last few years has made you concerned about the safety of your investments.

Perhaps you are reading Broken Markets because you wonder why correlation in the stock market, or the degree to which individual stock prices tend to move together, has never been greater. That’s because asset pricing in the stock market is largely the result of high frequency algorithmic automated traders, who make up most of the volume. They know nothing about the underlying companies whose shares they churn. They don’t even know the names or lines of business of the companies they trade. They don’t care, and there is a downside and a danger to that.

Perhaps you are reading this book because you want an answer to why the market can drop a thousand points within minutes, only to rebound just as fast, as the markets did in aggregate during the Flash Crash of May 6, 2010. Did that day frighten you? Make you lose enough confidence that you withdrew your money from the market? If you did, you were not alone. Some $232 billion has been withdrawn from domestic equity mutual funds between May 2010 and January 2012.1 However, if you did understand what caused the markets to drop that day and stayed in the market, you would have caught a major bullish move up.

Perhaps you are reading this book because you are “in the industry” and agree with our viewpoints—or you flat out disagree with us.

Whatever reason you picked up this book, we are hopeful you will come away from Broken Markets with an understanding of how and why our stock markets have changed in the past 15 years. We hope you will see the danger created for retail and institutional investors, as well as the United States and perhaps the world economy. We hope you will be outraged, as we are. We hope that you will be so outraged that you will make it known to your political representatives. Our short-sighted myopic tinkering with our market’s foundation has been done for the benefit of few, at the expense of many.

We wrote Broken Markets quite simply to try to explain the markets’ complexity to an audience that does not only include the most sophisticated industry insiders. Although we wish our markets operated in a manner simple enough that the majority of us could understand it, unfortunately, today’s markets do not operate in simple and intuitive ways. Hopefully, we can illuminate the murkiness to help you understand the highway upon which your investments are traveling.

If you are a buy-and-hold investor or a retail trader, we want you to come away understanding new dangers in our market structure that never existed before. We want you to understand that your costs are not just a commission or a bid-ask spread. Your every investment move, order, and trade is recorded and sold/provided to hyper-efficient, short-term HFT firms by the exchanges, similar to how your Internet-browsing is recorded by your search engine provider. However, while your browsing habits are sold to advertisers who make money attempting to sell you goods, your trading data is sold to HFT firms who trade around you and against you, and at your expense.

If you are a chief financial officer or investor relations officer at a publicly traded company, we hope this book helps explains some of the gyrations that your stock may be taking during the day. You probably have lost a lot of “color” on your stock since the specialist model disappeared and may be struggling to understand why your stock is suddenly going up—or down. This book will fill in the blanks for you. We also hope that you will add your voice to the market structure debate.

Ultimately, we hope you enjoy the read!

—Sal and Joe

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