Claim of a ‘rigged’ stock market ignites a debate

04/05/2014 6:32 PM

04/06/2014 2:14 PM

America’s stock market — dancing near record highs after its horrendous fall six years ago — has erupted in a firestorm of accusations and denials, with Kansas City in the thick of it.

“Stock market’s rigged” is what millions heard last Sunday on “60 Minutes.” Author Michael Lewis, of “Liar’s Poker” and “Moneyball” fame, championed the claims of his newest book’s protagonist, an inquisitive trader who didn’t like what he found.

Together they fingered the nation’s stock exchanges, Wall Street bankers and an esoteric group called high-frequency traders. Everybody else in the market, they declared, is a victim.

The blowback came out of Lenexa, home of Bats Global Markets. Bats was founded by Kansas City-based high-frequency trader Dave Cummings just nine years ago. But it now handles daily trading volumes that match the venerable New York Stock Exchange and Nasdaq Stock Market.

“Shame on you both for falsely accusing thousands of people and possibly scaring millions of investors,” Bats president William O’Brien told his adversaries during a live debate Tuesday on CNBC.

Last week’s stunning public displays revealed a long-simmering fight over how financial markets work. It already had caught the attention of big investors and investigators alike.

The FBI said it is digging into high-frequency trading, and New York’s attorney general is prying into industry practices that he has labeled “Insider Trading 2.0.” On Friday, U.S. Attorney General Eric Holder added the Justice Department to the list of inquirers.

They obviously are looking for illegal activity, but others say legal or not, what is happening should not happen.

At the same time, many agree that stock trades cost small investors less than ever and that their trades get carried out instantly. In many ways, the little guy is riding high.

Still, the “60 Minutes” piece rattled Stinson Dean’s memory of what happened when he bought shares of Sprint a few months ago. The Blue Springs resident said it prompted him to order Lewis’ new book, “Flash Boys.”

Finding fault

Dean, 28, doesn’t invest a lot, mostly stock in local companies he likes.

And he hadn’t thought much about the way his order to buy a few hundred shares of Sprint has been broken up.

He got 100 shares at the price he “plugged in” on his computer, but the rest cost him a penny a share more, even though he got those shares a second later.

“It was exactly what they said in the ‘60 Minutes’ deal,” Dean said.

What Dean and millions more heard was Brad Katsuyama explain his own problems buying stocks as head of trading at RBC Capital Markets in New York. A small part of the company’s order would get filled and the stock price would jump. Then he would get the rest of his order, but at the higher price.

It was like someone knew his order was coming. It took an expert in fiber optics and a lot of investigating, but Katsuyama concluded that’s exactly what is going on in the stock market every day.

Eric Hunsader, who sells real-time market data to traders as head of Nanex LLC, offered an explanation of all this to The Star, though he is not part of Lewis’ and Katsuyama’s efforts. It starts with the idea that as fast as computers move, they have speed limits.

So when Katsuyama’s stock order went to the market, it would reach the Bats stock exchange first. That’s because Bats’ computer center in Weehawken, N.J., was closer than the computer centers run by the New York Stock Exchange and Nasdaq in other parts of New Jersey.

Hunsader explained that high-frequency trading firms have their own computers at each of the exchanges’ data centers and buy direct access to the exchanges’ market data to follow what’s happening in the market.

The alternative is to watch markets through the “combined feed” that shows all the markets’ data together and that some argue is slower than the direct data feeds exchanges sell.

The claim is that the high-frequency trading firms’ computers would spot a big order as it hit Bats’ computers and use that information to trade on other exchanges’ computers milliseconds before the big order reached them.

Of course, the firms’ computers would have to beat Katsuyama’s order to the other exchanges, several milliseconds sooner, and that’s exactly what the “60 Minutes” piece said happens.

But Lewis and Katsuyama implicate the exchanges too.

Again, Hunsader explained: “It only works if the exchanges give the high-frequency traders the data faster” than everyone else gets the market data.

In short, it’s not that the traders’ computers are that much faster. They’re also getting a head start.

If that is happening, it is not supposed to. Just ask the New York Stock Exchange.

In 2012, it paid a $5 million fine for having accidentally delivered its data to some members faster than to everyone else. Regulators never claimed it was on purpose, and the exchange neither admitted nor denied what happened. But the fine stuck all the same.

No one gets a head start from Bats, spokesman Randy Williams said.

Bats sends its market data at the same time to every member who buys a direct feed. That covers 70 percent of the members, and they account for 97 percent of the trades at the Bats exchange, Williams said.

Some buy a faster connection, but the faster connection is available to any member who wants to buy it.

On top of that, Williams said, Bats also sends its data at the same time to the combined feed.


Hearing all this, some say small investors need not worry.

“The retail investor has never had a better seat at the table,” said outspoken markets advocate Harold Bradley.

He said it is “ridiculous” to call the retail investor a victim in today’s markets.

Like Katsuyama, Bradley once was head trader for a large firm, American Century Investments in Kansas City, and later became a mutual fund manager there. Before that he traded at the Kansas City Board of Trade.

As recently as 2012, he was the chief investment officer overseeing the Ewing Marion Kauffman Foundation’s substantial endowment. He is mostly out of the industry these days, but he still serves on the CFA Institute’s Financial Analysts Seminar Board of Regents.

Electronic markets — all those computers — have been a boon to the little guy, Bradley said, and many others agree.

Small traders pay less to trade these days, perhaps $8 a transaction. Their trading orders are filled almost instantly, with Fidelity ads guaranteeing one-second executions.

And stock sellers get nearly all the money that buyers pay when shares change hands. The difference, called the spread, is usually only one penny a share.

Bradley had spent much of his career pushing for electronic trading and reforms that he said have made markets this friendly for individual investors.

Before electronic trading took over and markets priced shares in pennies, stock quotes moved in larger fractions of a dollar — a quarter or an eighth, which is 12.5 cents a share.

As American Century’s head trader, Bradley battled the same problems that Katsuyama complains about. Information about orders was in the hands of trading floor specialists and others who made markets work, and it “leaked out” then too, he said.

Bradley’s point is that “leaks” now cost a penny a share, and he credits the way markets currently work for squeezing out those higher “costs” of past markets.

The little investor isn’t getting squeezed in the market, Bradley said, but is being dragged into the long-running battle over how markets should work.

“If you can get the little guy into the debate, calling the market rigged, then you get Congress willing to roll back some of these rules that took people like me decades to put into place,” Bradley said.

Big fish

Big traders, however, do have problems. Big trades are harder to get done.

That’s because the stock market has lost much of its depth, said Hank Herrmann, chief executive officer of Waddell Reed Financial Inc. in Overland Park.

“If everything’s trading 100 shares at a time, from a big trader’s perspective, that’s a problem,” Herrmann said. “It used to be 10,000 shares; now it’s 200.”

Big traders can deal with that by using brokers who have their own computer algorithms to work a big order into a market without disrupting prices.

It means those trades cost more to execute and reduce the returns of mutual funds popular with small investors.

Herrmann said high-frequency traders are one reason markets have gotten shallow, but so are other structural changes in how markets work.

One big change in markets is how many exist.

More than a dozen separate stock exchanges operate in the United States, four of them run by Bats. Stocks also trade on more than three dozen essentially private markets called “dark pools” because they don’t share their market data as the exchanges do.

Many in the industry point to the complexity as the source of recent high-profile problems.

The list includes the Nasdaq’s three-hour shutdown last August, Facebook’s bungled initial public stock offering in 2012 and many others.

Lewis said it’s the reason markets can be rigged.

“The complexity disguises what is happening,” he said on “60 Minutes.”


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