The Stock Market is Rigged (In Case You Didn’t Know)

“The United States stock market, the most iconic market in global capitalism, is rigged.”
– Michael Lewis, author

The Stock Market is Rigged (In Case You Didn't Know)On March 31, Michael Lewis’s Flash Boys: A Wall Street Revolt  was released to an expectant audience, some of whom had watched the author’s explosive and controversial interview the night before on CBS’s 60 Minutes. Creator of other popular books such as The Big Short, MoneyBall, and Liar’s Poker, Lewis has a knack for telling stories that involve math and finance.

In this story, Lewis tells of Wall Street insiders who started to realize around 2008 that the markets were behaving oddly. They would go to purchase stocks or commodities at the current price, and find that the order, or portions of a larger order, could not be filled at that price.

What was happening? High frequency traders, the machines that virtually run the New York Stock Exchange now, were rigging, or rather, skimming the trades. These high frequency trading machines could see the order, make a purchase, and sell the stock back to the person placing the order at a slightly higher price. While the price differential may be as small as one penny, the volume generated by high frequency trading turned these pennies into big profits.

As Lewis tells Steve Kroft, “One hedge fund manager said, ‘I was running a hedge fund that was $9 billion and that we figured that the, just our inability to make the trades the market said we should be able to make was costing us $300 million a year.’ That was $300 million a year in someone else’s pocket.”

Lewis along with a young RBC (former) broker, Brad Katsuyama, and a Ronan Ryan, an expert on high-speed fiber optic networks discovered that “the market moves at two speeds: one speed for people who pay for access to the exchanges, who put their trading machines right next to the black boxes … and everybody else. And we are everybody else.”

In the extended interview, Lewis uses the metaphor of “prey and predators,” with the prey being anyone who is invested in the stock market. Who does the rigging? “Stock exchanges, big Wall Street banks, and high-frequency traders,” says Lewis.

The book release and 60 Minutes feature generated much discussion online, with articles in major financial publications such as Bloomberg,  and coverage in countless independent blogs. However, as explosive as the “The Stock Market is Rigged” headline may be, the profits gained by high frequency traders at the expense investors may be the least of an investor’s worries.

One of the more alarming result of high speed trading is the ability of the market to react extremely quickly to events – long before individual investors or brokers can respond. During the flash crash of May 6, the S&P 500 fell about 1,000 points, or 9% of its value in mere minutes – representing $862 billion of U.S. equity values, according to Fortune – only to make an equally quick recovery.

Never mind calling your broker or planner to sell before things get too ugly; you can take a bath in the stock market in less time than you can run your bathwater at home.

Lewis is not the only author exposing the effect of runaway technology on the market. In 2012, Scott Patterson released Dark Pools: The Rise of the Machine Traders and the Rigging of the U.S. Stock Market  to rave reviews, such as Canadian Business, who called it: “an alarming account of a market rapidly slipping out of human control, and a slow-witted regulatory regime unable to keep up.” Dark pools represent the trading volume created by institutional orders that are unavailable to the public. The trades are facilitated away from the central exchanges and they make the market less transparent.

As MotherJones describes the brave new world of investing in their article, “Too Fast to Fail,”  “Despite efforts at reform, today’s markets are wilder, less transparent, and, most importantly, faster than ever before…. As technology has ushered in a brave new world on Wall Street, the nation’s watchdogs remain behind the curve, unable to effectively monitor, much less regulate, today’s markets.”

Not everyone has jumped on Lewis’s bandwagon. MercenaryTraders.com’s Jack Sparrow posted a thought-provoking critical review of Flash Traders  in which he defends high frequency trading (HFT) by saying that the system it replaced was even more problematic. (However, we don’t find his conclusions comforting.)

“Flash Boys is deliberately set up to suggest a ‘perfect world gone bad’ scenario: As if, prior to the advent of HFT, markets existed in a 1950s ‘Leave it to Beaver’ state where nobody ever got bad fills and liquidity was provided by a fairy godmother who never skimmed.” Sparrow asserts that it’s irresponsible, even deceptive to try and talk about HFT without talking about what HFT replaced.

First, floor traders and market makers have always had ‘privileges’ — since time immemorial — in exchange for providing liquidity. Second, floor traders and market makers of old used to flat out steal, a lot. Third, even when doing an honest job, those floor traders and market makers (especially within i-bank desks) took a lot bigger spread, on balance, than the HFT guys take…

In the late 1980s, the Justice department busted 46 traders and brokers in the Chicago trading pits. The stealing had gotten so bad, the FBI came onto the trading floor. At the turn of the 21st century, the stealing was still bad….

And then, too, you have the many billions the big investment houses (Goldman, Morgan etc) used to make on market-making activities…. Client order flow passing through a bank is like a bag of popcorn, or maybe a big chocolate cake. You reach in and grab some of the popcorn, or nick some frosting off the side. Bid ask spreads used to be huge, with most investors at the mercy of whoever was working them.

Even though the tiny HFT “tax” imposed on trades adds up to $160 million per day, Sparrow suggests that it is a low price to pay for the service of market liquidity. He goes on to compares HFT providing liquidity to casinos providing the service of attractive and secure gambling venues in Vegas – a bartender’s tip, flat rate fee, and/or a $3.50 ATM charge for Vegas tourists.

We think that casinos provide an fitting comparison, as far as the risks of stock market investing. The way to lose money fast in the market isn’t to pay extra pennies on your purchase; it’s to lose your capital when the house of cards comes down. What if it never does collapse? Then transactional costs, fees and taxes will continue to erode your wealth, year after year. Gains aren’t the only thing that compound over time – so do costs, and it is essential to measure opportunity costs.

MarketWatch’s Paul B. Farrell put it bluntly in his ranting commentary, “Yes, stocks are rigged, and fed is the biggest rigger“:

 Wake up. Wall Street was rigged from Day 1 when those 24 stock traders agreed they would jointly control all buying and selling of your stocks…. No surprise. Everyone knows it. Always has been rigged. Always will be rigged. Started when 24 stock traders met under Wall Street’s Buttonwood Tree in 1792. Called their new auction system NYSE. Part contract, part monopoly, part conspiracy.

…Forget reform. Wall Street will still be rigged in 2092, in 2392…. Insiders own the casino, they set the rules, they operate the games….

All those bad, con artist ‘Flash Boys’ will just invent new algorithms, new scams, new tricks, new ways to beat the system. Remember Gordon Gekko? New characters pop up. The next ‘Wolf of Wall Street.’ New Madoff. Milken. Minkow. Enron. New, bigger, more sophisticated Ponzi schemes.

Besides, Main Street’s gullible. As P.T. Barnum put it: ‘There’s a sucker born every minute.’ The real sucker is us. We buy the bull. High-speed traders know it.

Is the U.S. Stock Market Rigged? We think the evidence is compelling. You’ll find the 60 Minutes segment below, and the video along with transcript and links to 60 Minutes Overtime on CBSnews.com.

Where to invest, if not the stock market? The next few weeks, we’ll be exploring viable alternatives to the stock market that have worked well for our clients. Prosperity Economics™ offers a way out of the stock market madness! If you’re not already on our mailing list, join the hundreds who are and receive free bi-monthly updates!

Listen to Kim Butler’s interview with Todd Strobel on Guide to Financial Peace: “Is The Stock Market Rigged?”

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