The stock market has become so fast and complex that even veteran Wall Street insiders and hedge fund operators no longer understand how it operates. That’s the conclusion from one of America’s most respected financial journalists, Michael Lewis of Moneyball fame.
“It’s too fast to be done by humans, humans have been completely removed from the marketplace,” Lewis told CBS’ 60 Minutes of the present situation on Wall Street. In his new book Flash Boys, Lewis makes two conclusions some would call startling:
- Trading is done almost entirely by high-speed computer programs over which nobody has any real control. Many of these programs or algorithms can trade hundreds of thousands of shares of stock in the blink of an eye.
- Technically savvy individuals Lewis calls high speed traders can take advantage of this situation to inflate the price and stocks and make a profit at investors’ expense.
Is the Market Rigged or Simply Out of Control?
“The stock market’s rigged. The United States stock market, the most iconic market in global capitalism, is rigged,” Lewis told 60 Minutes Correspondent Steve Kroft. He claimed that big banks and high volume traders were able to manipulate the market in such a way as to rip off investors.
Yet some of his conclusions point to something more frightening: The market might be out of control and nobody understands how it really works. In the book, Lewis tells the story of Brad Katsuyama, who was formerly the head of the Royal Bank of Canada’s (RBC) New York trading operation.
Katsuyama noticed that somebody was able to literally beat his traders to the punch when they traded to make major deals. The traders would try to buy large blocks of stock only to discover that somebody else had bought the same shares seconds before they did.
“The insiders are able to move faster than you and see your order and play it against orders in ways that you don’t understand,” is how Lewis described the arrangement.
Prey and Predators
“It’s prey and predators and the prey is anybody who’s actually an investor, anybody who’s even speculating in the stock market,” Lewis said. “Anybody who doesn’t have the speeds of the high frequency traders, they’re the prey.”
“You’re either in or you’re out,” Lewis said of the market. “What’s interesting is: Who’s out? … Outsiders include the most sophisticated richest hedge fund managers in the world, the biggest pension funds, the biggest mutual funds in the world along with the guy with his E-Trade account. They’re all in the same position.”
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Lewis claims that some of the world’s most sophisticated investors, including hedge fund titans, have been burned by the system and are just as likely to lose money as average traders. Katsuyama made the same disturbing discovery.
After discovering that hedge funds and other big traders were having the same problem, Katsuyama investigated and made an interesting find. Traders operating on BATS, an electronic exchange in New Jersey, could see trades before others. They could buy shares first and drive up the price — and then sell it and make a profit.
“It just didn’t feel right, it didn’t feel right that people who are investing on behalf of pension funds and retirement funds are getting bait and switched in the market,” Katsuyama told 60 Minutes. “People are blindly losing money they don’t even know they’re entitled too.”
Basically the high speed traders can artificially inflate the price of stocks because they can trade before you do. They can do this because they have figured out how to essentially put up a toll booth and charge anybody who wants to trade.
Katsuyama has built a new exchange, called IEX, that puts up speed bumps to block high speed traders. He thinks that this system will be able to fix the problem.
Could it Lead to a Bubble?
The worst thing about the system that Lewis describes is that it could easily lead to a bubble and a massive stock market crash. If Lewis and Katsuyama are correct, the bull market of the last few years might be completely artificial.