Checking in to the Roach Motel

April 22, 2014 

I recently read Michael Lewis' new book "Flash Boys" and originally thought the title to this article would be something like "The Need for Speed." After reading his book I've decided that speed is not the demon here.

We humans have always had a need for speed… the fastest car, boat or plane, or the fastest mile to name just a few examples. The "Flash Boys" is about high frequency trading. Being fast allows one to get to the trade first. To be the first to act on public information can be quite profitable. To act on non-public information is illegal and we are not discussing that here.

Remember the old black and white courtroom dramas when the judge pounds his gavel and barks aloud the verdict? All the reporters in the back of the courtroom race out to the nearest telephones to call in their reports. The first one to do so gets the "scoop." High frequency trading is the same idea. Only instead of minutes it took the reporters to call in it now takes only milliseconds. There are about eight milliseconds in one blink of the eye.

There are three ways, according to the book, that such trades make money. The primary way they make money is through what is called "slow market arbitrage". An example of this would be a bond that has a different price on two or more exchanges. These prices are typically quite narrow. The quick trader can buy that bond low on one exchange and sell that same bond on another exchange for a slight profit. And good for him or her, that's capitalism.

Now add the speed of the computer to that scenario and you get the picture. Where it once was someone tediously scanning the inventories for prices discrepancies he or she could exploit, the computer can do the same scanning in only seconds. So where I once in a while, back in the late '80s or early '90s, got a

call from someone looking for a "slow market arbitrage" I get none now. Those traders have been replaced by computers.

If that were all to the story it would end there. Being faster is not bad. It's the roach motels that leave a bad taste in one's mouth. Yuck. The roach motels in this case are the 19 public and the 45 some odd private exchanges. The private exchanges are often called by the alluring names of "dark pools" or the "black box." No one sees the transactions inside of them.

Their original (or stated) purpose was so investors could trade large blocks of stock without affecting the price of the stock as could happen on a public exchange. A good idea in theory until the HFT's started renting space on them.

The high frequency trader rents space on these exchanges so they can trade if they wish with any order that enters the space. That, in my humble opinion, creates conflicts of interest. That means if you are investing through some entity that owns a dark pool and receives rent from one or more HFT's that want to use that pool guess where your order is going to be routed? It gets more complicated than my example particularly when these HFT use sophisticated algorithms to race around all of the exchanges to trade ahead of typical workflow. But, I think you get the idea.

Bare knuckle fighting

Perception is everything, particularly to the main street investor. It seems once again that the cards are stacked against them. But all is not lost. Wall Street, particularly at that HFT level, is capitalism at its purest. It is tough, bare knuckle fighting. It always has been and hopefully always will be that way. It isn't pretty, but it is the best system in the world. The "Street" will take care of any imbalances' these traders may cause. The book mentioned one seven billion dollar hedge fund that paid something like three hundred million to the HFTs. I am very certain that this fund manager and others like him are not happy to lose anything to the HFTs much less the amount mentioned. They will do something to correct this. Not for the good of mankind but for themselves and their investors. We don't need another government regulation. This situation began because of a previous regulation.

How does this affect the individual investor? A little, I am sure, but not enough to make much of a difference if one is investing for the long haul. Another reason to be an investor and not a day trader.

Michael T. Doll, an Investment Advisor with the Longboat Key Financial Group, can be reached at 941-383-2300 ext 6 or Michaeltdoll@longboatkeyfinancial.com or visit michaeltdoll.com

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