What don’t we know about the way the markets work?
In a perfect world, the financial markets would be entirely transparent and without mysteries. In this imperfect one, we have financial markets reliant on high-speed trading and dark pools, both of which are imperfectly understood. Thanks to the bestselling Flash Boys: A Wall Street Revolt and other journalistic efforts, the public is more aware of them.
While alternative trading platforms such as IEX (founded by Brad Katsuyama, the central figure of Flash Boys) have emerged, the anxieties remain. Reforms to U.S. market structure take time - often, too much time. At present, as Flash Boys notes, major U.S. exchanges such as the NYSE and NASDAQ have sold prime access to their premises to high-frequency trading networks, giving that software a clear competitive advantage over fund managers and individual investors.1
Q: Does high-speed trading hurt individual investors? Lewis (who used to work on Wall Street before becoming a journalist) contends that the machinations of high-frequency trading amount to "computerized scalping" with the small investor paying a "tax" of half a percent (or less) per trade. Some economists and consumer advocates have argued for a "Robin Hood" tax in response - a surcharge of 3 basis points on financial transactions, with revenue generated going to the Treasury and helping to whittle down the federal budget deficit. Other economists call that a lousy idea, saying that taxing trading would only amount to a tax on savings - any such levy would ding the small investor even more, they argue, and Wall Street firms would just hunt for ways to avoid the tax.2
Other stock market analysts feel high-speed trading helps investors more than it hurts them , citing what they see as improved market liquidity and referring to the reduction in bid-ask spreads (the differential between what buyers want to pay for a stock versus what sellers believe it is worth). Since the mid-1990s, bid-ask spreads have narrowed from the vicinity of 90 basis points to about 3 basis points as an effect of such trading networks.3
Q: How long will high-speed trading rule the markets? ? It doesn’t really "rule" them at the moment, but it does account for about half of all U.S. market volume right now. If it is any comfort, the percentage of market activity conducted via algorithmic trading platforms declined by 10% in the current bull market (according to The Atlantic, it went from 61% in 2009 to 51% in 2012). 3
Q: What really goes on in dark pools? For the uninitiated, dark pools are the private trading platforms maintained by banks. We can’t see what goes on inside these private trading venues, as they aren’t public exchanges like the NYSE or NASDAQ. The SEC is finally investigating them - its current chair, Mary Jo White, thinks they "risk seriously undermining" the credibility and validity of stock prices.4
Dark pools account for about 40% of equities trading in America, and they aren’t policed nearly as much as the public exchanges. As there are 11 public stock exchanges in this country compared to 40+ dark pools, there seems to be a sizable amount of trading going on behind closed doors.4
Brad Katsuyama, the former Royal Bank of Canada trader who spearheaded the reform movement chronicled in Flash Boys, plans to introduce a pricing system that will let most banks and brokerages trade on the IEX platform for free - a move that might encourage them to get out of the dark pools (where they face no fees that they would ordinarily incur for trading on the public exchanges) and bring more of their trading into the light. But even IEX currently operates as a dark pool - though it plans to register with the Securities and Exchange Commission soon and become a full-fledged exchange - and its proposed pricing system would explicitly favor brokerages over individual investors.4
Will trading ever truly be transparent? It would be naïve to think so, but there is room for improvement. When even key players on Wall Street admit that they have been in the dark about trading mechanics (as Michael Lewis discovered in researching Flash Boys), something has to change and change soon. 1
This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
1 - tinyurl.com/kuah7pf [4/1/14]
2 - nytimes.com/2014/04/08/business/argument-for-financial-transaction-tax-regains-footing.html [4/8/14]
3 - theatlantic.com/business/archive/2014/04/everything-you-need-to-know-about-high-frequency-trading/360411/ [4/11/14]
4 - tinyurl.com/lac32yy [7/7/14]