Whether or not you believe the stock market is a zero-sum game, it is frustrating when you see someone being given an unfair advantage. After all, markets are only open and efficient when everyone has the same information — this is the reason that insider trading is illegal.
So it is height of hypocrisy that the same stock exchanges that extoll the benefits of open markets are providing advance insider information to investment firms — in exchange for money — before they provide the same information to the general public. It is called high-frequency trading, or flash trading, and this is how it works. When the price of a stock starts to rise, this information is provided to an investment firm like Goldman Sachs, who pay for it. The key is that this information is provided a split second before it is made available to everyone else. In a recent example detailed in the NY Times, this information was provided three one hundredths of a second (0.03 seconds) early. This might not sound like much, but the big investment firms have powerful computers sitting right next to the stock exchange, which are able to initiate thousands of trades in this amount of time (remember, a typical modern personal computer can execute 90 million instructions in 0.03 seconds, and their computers are even faster).
The problem with this is that when they buy the stock, based on information that someone else doesn’t yet have, whoever is selling the stock doesn’t get as much money. If the seller also knew that the price was rising, they could get a higher price, but the information that their computer sees (or more likely, their stockbroker’s computers) is that the price is still low. The investment firm pockets the difference and they win. If you happen to be the person selling the stock, your stockbroker can’t get as much money for it, and you lose.
So, how much money are the big investment firms stealing from normal people like you? Not surprisingly, the stock exchanges don’t provide this information, but we do know that over half of all trades are being done by high frequency traders, and these select traders made $21 billion in profits in 2008 alone. Some people believe that market volume has increased 164 percent since 2005, largely due to high frequency trading.
How do you think banks like Goldman Sachs recovered so fast after the recent economic collapse? According to the former chairman and chief executive of the NY Stock Exchange “This is where all the money is getting made. If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage.”
The big problem, as the head of US equity trading at T. Rowe Price (a firm that uses high frequency trading) puts it is “We’re moving toward a two-tiered marketplace of the high-frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity.”
Senator Chuck Schumer is calling for a ban on this practice, saying “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.”
What happens when the markets lose their integrity, because individual investors don’t think they have a fair chance? The markets collapse.