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Are The Markets Rigged?

No sooner had Flash Boys author Michael Lewis finished speaking, before 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 gotten 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, 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 HFTs 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 HFTs to allow them to jump in front of other people’s trades—but after the HFTs 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 HFTs comprise about 50% of daily stock trading volume, the stock exchanges really like the HFTs.

So back to the original question: Are the markets rigged? This statement may be a bit of exaggeration by the author 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 HFT firms.

For the average person, the HFT 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 over very long periods of time.

So is HFT 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.

Originally published May 21, 2014, Victoria Advocate