This Blog Has Moved!

My blog has moved. Check out my new blog at realfreemarket.org.



Your Ad Here

Saturday, August 8, 2009

The 30 Millisecond Trade-Ahead Scam

I noticed this scandal recently. Other people asked me about it, but I only saw the story recently. I think people were asking me about it, but their question wasn't specific. If you want me to comment on a specific story, give me a link so I know what you mean.

The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.

The NYSE also has such a system. The specialist gets to see the orders ahead of everyone else. When the specialist places his order, he does so *AFTER* everyone else.

Suppose the NYSE order book is as follows:

Offer 500 shares at $10.00
Offer 500 shares at $10.01

An order comes in to buy 1000 shares. Now, the specialist (actually his computer) makes a decision.

The specialist can allow 500 shares to be sold at $10.00 and 500 shares to be sold at $10.01. Alternatively, the specialist can sell 500 shares from the order book at $10.00 and sell 500 shares from his own account at $10.00. The specialist's computer will do whatever it thinks is most profitable.

Superficially, you might say "The specialist did a good thing. He saved the buyer $0.01 times 500 shares." The problem is that the person selling 500 shares at $10.01 was disadvantaged. He should have gotten a fill, but he didn't. Now, if the market goes up, the specialist can buy from that person at $10.01. If the market goes down, then the order at $10.01 was cheated.

Because the specialist gets this perk, other people don't attempt to compete with the specialist at making markets. The specialist profits from this, but every other market participant pays higher prices.

It's the usual "seen vs. unseen" fallacy. You see the specialist improving market quality. You don't see other market makers competing with the specialist. The value of the specialist's perk is so great that it doesn't pay to compete with him.

The NASDAQ has a similar loophole. If you're a "qualified market maker" (i.e. insider), you get a peek at orders ahead of everyone else. You might say "big deal, 30 milliseconds", but it's enough to profit.

As usual, an example illustrates the scam.

Suppose the NASDAQ order book is:

Offer 500 shares at $10.00
Offer 500 shares at $10.01
Offer 500 shares at $10.02
Offer 500 shares at $10.03

Someone places an order "Buy 2000 shares at market." An insider's computer gets the 30 milliseconds free look. The insider's computer will buy 500 shares at $10.00, $10.01, and $10.02. Then, 1500 shares are sold back for $10.03 to the incoming market order.

The insider made a guaranteed riskless profit, from his ability to get the 30 millisecond free look. The person who placed the "Buy 2000 shares at market." order was disadvantaged.

Again, the "seen vs. unseen" rule applies. These insiders get a perk. Everyone who isn't an insider suffers via higher prices. It doesn't pay to start a market making business unless you're large enough to buy this perk from the NASDAQ.

If you own shares of a hedge fund or mutual fund, you pay the cost of this perk. It comes out of the fund's returns.

If you're an small individual investor, you pay the cost of this perk. However, an extra $0.02 per share when buying is negligible.

Another example of this is "Payment for order flow." Suppose you work on the trading desk at Goldman Sachs or another large brokerage. When an order comes in, you have two choices. First, you can send the order out to the market and get the price there. Second, you can fill the order from your own account. This is legal as long as you give the current market price. You might say "This good for the customer!", but it's the same problem as the above examples. The trader at Goldman Sachs makes a profit, but all other market participants are disadvantaged. This information perk is very valuable. It's profitable for a broker to pay other brokers to route orders through them; this is "payment for order flow".

The net effect of all this is that you don't have a profitable market making business unless you have a special information perk. The specialist on the NYSE, the "30 millisecond free look NASDAQ traders", and the person on the trading desk at Goldman Sachs all get special perks, compared to other market making participants. It's almost impossible to have a profitable market making business unless you have one of these special perks.

Once I realized that the stock market is one big scam, I lost interest. The stock market does not outperform true inflation over time. You can avoid market manipulation by buying physical gold and silver and taking delivery. There are huge State-imposed transaction costs for someone who buys gold and silver, but you only pay the cost once when you buy from a State-licensed vendor. For this reason, "Develop a gold/silver/FRN barter network!" is on my list of agorist business ideas.

No comments:

This Blog Has Moved!

My blog has moved. Check out my new blog at realfreemarket.org.