Michael Lewis spotlights high-frequency traders with his new book, Flash Boys. These traders use high-speed computers and fast connections to outrace investors, and other traders, to the market. They now account for more than half of all U.S. stock trades. And the flash boys spend billions to save milliseconds (by, for example, laying expensive fiber-optic cables directly between exchanges in Chicago and New York).
A race that is faster than the blink of an eye is hard to conceive. But many of the strategies are easy to understand—the front-running of trades and the manipulation of orders.
The Securities and Exchange Commission (“SEC”) can, and should, regulate the worst abuses–and its absence is befuddling. But there is another possible solution: Tax high–frequency trades. The French already do it. With some modifications, so could we.
After all, flipping stock in milliseconds enriches only the traders–not the efficiency of our financial markets. And other investors pay a price.
Say, for example, you want to buy 1,000 shares of ABC stock, which you expect to appreciate substantially. You ask your broker for the “bid,” which is the highest price a current buyer is willing to pay, and the “offer,” the lowest price a current seller is willing to accept. Say, the bid is $10 a share and the offer is $10.05 on the consolidated market (a national best bid and offer is consolidated from all the exchanges).
Now, if you direct your broker to buy 1,000 shares at $10.05, you expect your broker to fill your order instantly—at least if the size being offered is 1,000 shares or more. But too often only some, or perhaps none, of your order is filled at that price.
What happened? Well, a high-frequency trader beat your order to the market—and the “offer” moved away from you, to say $10.10.
How did this happen? According to Lewis, the market is rigged. An exchange may pay your broker to route your trades through it. The exchange may then allow a high frequency trader to peek at your order on its way to the broader market. This allows the trader to buy stock ahead of you and other investors. The trader can later sell the stock to you or another investor at a higher price.
There are other problems: A high-frequency trader may offer to sell a small number of shares, say 100 shares, simply to move to the front of the consolidated price queue, to tease information out of other investors. Your order for 1,000 shares is routed first to the high-frequency trader, who will sell the 100 shares to you, and perhaps the remaining 900 shares, if the trader can buy the shares at a lower price. The trader effectively acquires an option to sell 900 shares to you at $10.05 for a short period of time.
A related problem, which I have seen often-but is not described by Lewis, occurs if you try to post a better “bid” at the front of the price queue (for example, to buy 1,000 shares at $10.01), Before your bid is displayed, the high-frequency trader will bid to buy 100 shares at $10.02. Because of the high-frequency trader’s early glimpse of your bid, the trader knows your bid exists, but the other market participants will not see it. And, if you try to move your bid to $10.03, the trader will move his to $10.04 (and, again, conceal your 1,000 share order from other market participants).
The SEC can, and should, prevent advance peeks at trades. But a high-frequency tax also could limit market manipulations.
The French apply a high-frequency tax to traders that (1) use computer algorithms to determine the price, quantity, and timing of their orders (2) use a device to process these orders automatically, and (3) transmit, modify, or cancel their orders within half a second. The French charge .01 percent of the value of stock orders a trader modifies or cancels that exceeds 80 percent of all of the trader’s orders transmitted each day. As a result, a trader pays a tax on orders that are not filled—which increases his cost of placing small information-gathering orders. (The French also collect a separate financial transaction tax on completed orders.)
There are pros and cons to the French high-frequency tax, but some variation may be desirable. A properly-structured high-frequency tax would cap the value of speed—to end the race to spend billions to save milliseconds. It also would charge traders to tease information out of investors. But it should exempt participants who contribute beneficially to the markets–like market makers that are registered with an appropriate national securities exchange.