This week CNBC viewers were treated to a lively on air discussion. Brad Katsuyama, founder of the upstart exchange IEX, along with Flash Boys author Michael Lewis, debated BATs Global Markets Exchange president William O’Brien about the topic of Michael Lewis’ book and the reason for starting IEX; are the stock markets rigged?
In his book, Lewis asserts that high frequency traders, also known as flash traders, who utilize price disparities and superior technology to earn a profit in fractions of a second, are working in collusion with large Wall Street players and are skimming the everyday investor. Mr. Katsuyama shares Mr. Lewis’ thoughts, and has even gone so far as to figure out the nuts and bolts behind what everyone knew was already happening. Mr. Katsuyama’s exchange serves hedge funds and mutual funds, billing itself as an exchange that is immune to high frequency trading.
BATs president William O’Brien took exception to the assertions made by Lewis and Katsuyama, and 20 minutes of undoubtedly the most entertaining television in CNBC history took place.
While Mr. O’Brien may disagree with Mr. Lewis and Mr. Katsuyama, flash trading is nothing new to the markets and is certainly a problem. Until now, not many people knew exactly how it worked, to which Mr. Katsuyama has shed light on.
While the explanation is much more technical and in depth, essentially flash traders are able to pick up on orders being processed at the BATs exchange servers or the NYSE servers and front run the orders by placing their own buy orders in front of your buy orders. Using high speed fiber optic cables, these orders can reach their final destination faster than yours do, and the result is that you pay a little more per share, let’s call it $.01 more per share than you would have before. While this does not seem like a lot, this is being done millions of times a day over the course of fractions of seconds, which can result in huge profits.
What had Mr. O’Brien up in arms was Mr. Lewis’ use of the term “rigged” to describe the stock market. Let’s be clear; the US debt and equity investment system is not a rigged game. There are certainly problems with it, as Mr. Katsuyama has proven, but we as Main Street investors are perfectly safe. What this discovery proves is that advances in technology can not only be used for good but for unfavorable purposes as well. Flash traders have found a way to front run your purchase orders in a legal way; they have taken an illegal activity and found a costly loophole to make it legal, which has earned those traders significant profits.
In any business, from retail products to investment exchanges, competition is always a good thing. Providing the public options will allow the strongest and most efficient solution to triumph, as determined by the market, and the stragglers will deteriorate and disappear. It is unfortunate that the use of the term “rigged” spooked some investors, but at the same time those investors deserve to know that this is happening. If you have concerns about what this could mean to you, be sure to contact an investment professional, and do not be afraid to write letters to your local Congressperson, to the SEC and to FINRA, demanding that they do their jobs and keep investors safe.