Financial advisors may be getting a few phone calls from concerned clients this week after a 60 Minutes report on CBS Sunday night asking whether the U.S. stock market is rigged.
The broadcast interviewed bestselling author Michael Lewis on his new book, Flash Boys, the story of three Wall Street professionals who independently discover how the market is rigged by high-frequency traders and band together to fight the exchanges exploiting ordinary investors. The book is also excerpted in today’s New York Times Magazine.
The book and the high-level media attention it’s getting has already provoked governmental reaction. The Securities and Exchange Commission says it is engaged in an “ongoing review,” and New York State’s attorney general, Eric Schneiderman, had this to say on Bloomberg Television this morning:
“There are some things here that may be illegal. There are some things that may now be legal that should be illegal or that the markets have to be changed. So part of what we're doing here in addition to looking for illegality is shining a light on this area."
For perspective on an issue that directly impacts all advisors and their clients, ThinkAdvisor reached out to Bob Seawright.
The chief investment officer of San Diego-based broker-dealer Madison Avenue Securities is one of the industry’s genuine thought leaders, a widely read blogger and a regular contributor to Research Magazine and ThinkAdvisor. True to form, Seawright, who has previously written on high-frequency trading, had seen the broadcast, read the book excerpt and said Lewis’ new book was expected in today’s mail.
ThinkAdvisor: Some commentators are saying there’s nothing new under the sun — the market has always been rigged to some extent so get over it.
Seawright: I understand that argument but I think it’s wrong because people in my position and our clients should be extremely unhappy with the various exchanges and the exchanges’ willingness to sell investors as a whole down the river for the sake of the trading volume created by the high-frequency people.
It’s a lot of cash in the exchanges’ pockets, and it’s cash coming out of the pockets of everybody else.
ThinkAdvisor: Should ordinary clients forgo investing?
Seawright: No. For the average mom and pop, it is costing a few cents a year; the biggest conglomerate investment houses stand to lose a lot more.
Seawright: That’s the insidious part of it. It’s not something that you readily see. You hit enter on your order and you get filled in part or filled at two different prices and the assumption always was, “Well, that’s where the market was.’
And the reality is that is where the market was, but the market was there because somebody stepped in between really, really fast.
For retail shops like ours it’s not a [significant] issue because our orders aren’t big enough that’s somebody’s going to step in front of them. If somebody’s buying 100 shares of something, there’s not enough money to be made stepping in front.
But when a client owns a mutual fund, and the mutual fund is trading shares, and somebody steps in front of that, it matters significantly to the portfolio as a whole, and by extension it matters to some extent to investors: 2 cents a share is a rounding error, and I get that.
On the other hand, the high-frequency trading firms are spending hundreds of millions of dollars to get another couple milliseconds of an advantage. Clearly it’s a real advantage to them, and that money’s coming from somewhere. That money is coming out of our clients, mutual fund clients and everybody else that’s involved in the market, and that ought to concern all of us.
ThinkAdvisor: So what can market participants do to overcome this unfair advantage?
Seawright: IEX [the new firm created by the heroes of Lewis’ book] is designed to take the speed advantage out of the market. You can always trade on the IEX to deal out the high-frequency people and we can [respond] as an industry to try to ameliorate the problem.
IEX is a new exchange. Goldman Sachs is an early adopter and before long people like us will be able to, as a practical matter, be able to direct substantially all of our business to the exchange.
I’m meeting with my traders today to talk about what we can do to make sure our clients get the maximum level of protection.
We’re doing what we can to mitigate the problem for our clients. I wish it would be as easy as to just flip a switch and be able to change what we do instantly.
But it’s going to happen to the extent it hasn’t already. Ultimately I think it’ll happen because there is no argument for letting somebody step in front of you.
Seawright: I haven’t seen a lick of evidence of this. If I put an order in and somebody legally front-runs it because they have a faster connection, the only people who benefit are the exchange and the high-frequency trader who got in front. I don’t see any benefit in that category of investor hanging around. That’s not investing, and it’s not even trading. It’s simply having an enormous information advantage … that can only be exploited with enormously expensive computing power.
Some say if there’s a way to exploit market inefficiencies, more power to them. I say you can’t trade on inside information ever. If you’re an insider at a company you can only trade at certain periods … It’s like my getting access to someone else’s company report before anyone else allowing me to trade on it.
ThinkAdvisor: Sounds like a pretty good gig if you can get it.
Seawright: The great thing about high-frequency traders is if you’ve read some of the press reports about them, they all pretty much make money every month.
If you make money all the time, you must have a particular advantage, and in this case it’s an information advantage. If you’re trading on an information advantage and you’re always winning and … the exchanges have decided it’s perfectly legal, why wouldn’t you do it?
You’d spin it the way they have: It’s providing liquidity. Who doesn’t like liquidity?
The [increased] attention placed on this by the industry press is a really good thing.
By Bob Seawright on ThinkAdvisor: