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This chapter is from the book

Why Have We Allowed This to Happen?

Part of it is that intense lobbying by Wall Street, including the exchange operators, pushing for this to happen with regulators and politicians in DC. A larger part of the answer is we have all been told a nice story about cheap $8 or lower commission trades, ample liquidity, and inexpensive trading costs. We all bought into the notion that our markets are so tight and efficient that there is no downside, only upside due to the new efficient ways the markets work.

There are reasons why brokerage firms offer $8 trades to retail investors, when so often that fee doesn’t cover costs. Today, these brokerage firms make money off retail orders in different ways. Money that used to be made mostly through commissions is now made through trading around that order flow. For example, your online broker likely sells your order to a “market maker,” rather than routing it to an exchange. That market maker is an HFT expert and gets first crack at deciding whether to be on the other side of your order or route it to an exchange. It makes this decision based on its internal short-term price prediction models. Armed with up-to-date information on all the retail order flow that they buy, its algorithm decides whether your retail order is “dumb” or “informed” and acts accordingly.

At times, HFT has a parasite/host relationship with investors. HFT works well only when there are sufficient hosts in the pool upon which to feed. When the hosts dwindle, due to lack of confidence in the system, and funds flow out of equities, HFT firms suffer. They begin to trade with and against themselves. The more the equity markets become unbalanced, the more HFT predatory effects become visible. Picture a watering hole in the wild teeming with crocodiles. Other animals aren’t afraid to drink at the hole because they don’t see the crocs beneath the surface. If there is a drought, however, the water line drops. The crocs become visible, and the other animals stay away.

There also is a big structural risk in the way retail orders are handled today. Take the May 6, 2010 Flash Crash, for example. Most Americans are aware of the market’s jaw-dropping 700 point decline and frenetic rise again that day. Billions of dollars of asset value were erased and almost restored in a period of minutes. Had the decline happened near the closing bell, you could not even begin to guess the damage that might have been inflicted on world markets in a domino effect. A big part of why the market unraveled that day is a direct result of HFT market makers who had purchased retail order flow from investors. At blazing speeds, they picked orders to which they wanted to be the contra-side and routed all others in such a way as to sell major well-known, well-capitalized stocks down to a penny.

Since 2008, we have been warning in our writings and TV appearances that HFT market makers would shut down and run for the hills at the first sign of stress. Under duress, HFTs would not be liquidity providers. They would be demanders and consumers of liquidity the likes of which the public has never seen. Their speed and information advantage on May 6, 2010 ensured that scared retail investors never had a chance. The story of the Flash Crash is that the market failed that day. It was exposed as a conflicted and rigged game in which only the connected insiders stood a chance. Every investor and market participant in the United States had been sold a lie: HFT liquidity was a blessing that lowered costs and helped investors, and it would be there in stressful markets like the market makers and specialists that it replaced.

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