October 8, 2013
Putting a Speed Limit on the Stock Market
By JACOB GOLDSTEIN
When Brad Katsuyama was running the U.S. trading desk for the Royal Bank of Canada, his clients would send in orders every day, but every day, when Katsuyama went to buy or sell, something would go wrong. When he wanted to buy, offers to sell shares would suddenly vanish, and the price of the stock would shoot up. When he wanted to sell, the same thing would happen in reverse. “I started to realize that, day in and day out, I was getting screwed,” Katsuyama told me recently.
The problem was that he was often too slow. Back then, in 2007, the stock market was in the middle of a significant shift. A combination of new technology and new regulations had led to the rise of firms focused on high-speed, computer-driven operations known as high-frequency trading. With the help of complex algorithms and ultrafast Internet connections, the new traders could buy and sell stocks in fractions of seconds, looking to make a seemingly infinite number of quick, tiny profits that added up. By 2009, high-frequency traders were making billions of dollars a year, and their transactions accounted for about 60 percent of U.S. stock trades.
Some of these traders acted like useful stock-market middlemen, constantly buying and selling, bridging the bid-ask gap between other buyers and sellers. But plenty of others used the new technology to foil long-term investors by trading ahead of the slower players. A trader’s algorithm might detect that Katsuyama was trying to buy 100,000 shares of a stock and then immediately start buying it to drive up the price. Indeed, certain high-frequency traders were forcing long-term investors, including those who managed funds that held ordinary people’s retirement accounts, to constantly buy higher and sell lower. The game seemed rigged.
At first, Katsuyama responded by creating an algorithm intended to make it harder for high-frequency traders to race in front of his trades. But then, he told me, he realized his clients’ real problem was not the traders themselves; it was the stock exchanges. As high-frequency traders proliferated, these platforms were adding clever services to attract their business. “If you want to solve the problem, you go to its root,” Katsuyama said. “And at the root, the problem is the market.” So last year, he and a few of his colleagues decided to leave the bank and start a new place for investors to trade. Rather than woo high-frequency traders, they would limit their advantages. Their trading platform, IEX, is set to open later this month.
The rise of high-frequency trading is often told as a technology story. Hedge funds, Wall Street banks and other firms used increasing computing power to write ever-smarter, ever-faster trading algorithms; fantastically expensive fiber-optic lines were built to increase transaction times by milliseconds. But the rise of high-frequency trading is also a result of the unintended consequences of regulation. Back in the ’90s and mid-aughts, a series of S.E.C. rules were designed to help ordinary investors by forcing stock exchanges to compete against one another. Exchanges could no longer hoard orders; if a better offer existed on another trading platform, they’d have to send it there.
It was a well-intentioned idea designed to better match buyers and sellers, but it wound up complicating things. New exchanges quickly arose to attract customers, and what is blandly referred to as the stock market soon became a complex web of more than a dozen separate exchanges. Today, it’s not just the familiar New York Stock Exchange and Nasdaq, but also lesser-known ones with names like BATS and Direct Edge. Exchanges are now basically just technology companies, rooms full of computers that match buyers and sellers. There are also roughly 50 so-called dark pools, which allow traders to trade the same stocks that change hands on ordinary exchanges but don’t require participants to post as much information. (IEX will be a dark pool with plans to grow into a full-fledged exchange.) “I don’t think anybody who was putting these rules together envisioned we would have 13 exchanges,” Charles Jones, a finance professor at Columbia Business School, told me.
The recent proliferation of places to trade has forced exchanges to compete more aggressively for business. And because exchanges make money partly based on volume, it was natural that they would compete against one another to court high-speed traders. (High-speed trading has fallen off a bit from its peak a few years ago, but it still accounts for about half of all stock trades.) This competition, Katsuyama says, led the exchanges to put the needs of high-frequency traders before those of long-term investors. They created a new system of rebates and fees for different traders that, according to one analysis, cost long-term investors billions of dollars. Exchanges also started renting out space right next to the computers that powered the exchanges. Since information takes time to travel over networks, traders whose computers were next to the exchange’s computer would know what was happening on the exchange fractions of a second before traders whose computers were farther away. And those fractions of seconds could mean billions of dollars. No wonder Katsuyama felt cheated.
The beauty of the stock market is that it’s an astonishingly easy place for buyers and sellers to connect with one another. If you want to sell almost any stock, you can find a buyer within seconds and know within a few cents how much the buyer will pay. (Compare that with selling a house or a car or even an old piece of furniture on Craigslist.) In the old days, the stock market worked because there were people — so-called market makers — whose job was to ensure that there was almost always a willing buyer and seller for every stock. In the past decade, their jobs have been largely replaced by high-frequency traders who provide this middleman service. Over time, this shift to technology has generally made it cheaper for everyone, including long-term investors, to buy and sell stocks. But there are notable exceptions. A trader using a high-speed connection to jump in front of a deal between a willing buyer and seller is
driving up costs for the buyer and isn’t really improving the market.
The goal with IEX, whose owners include mutual-fund companies and other big investors, is to attract only the high-frequency traders who add liquidity and keep away those looking for the kinds of advantages that Katsuyama says are unfair. IEX’s computers will be set up so that, no matter how far away traders’ machines are, everyone will get market information at the same time. IEX also won’t offer many of the special order types favored by high-frequency traders. Other exchanges have created complex structures of fees and rebates that have led to payouts for some traders and higher fees for others; at IEX, everyone who trades will pay the same amount. “People are always looking for ways to game the market,” Katsuyama says. “They’re always looking for ways to get an edge. It’s our job to make sure that edge doesn’t exist.”
Other trading platforms have tried, in recent years, to appeal to big investors who feel as if they’re getting shortchanged. But they’ve had a hard time attracting enough business to make it easy for buyers and sellers to connect, according to Manoj Narang, of the high-frequency trading firm Tradeworx. In practice, it can be difficult to distinguish between high-frequency traders who are simply adding liquidity and the ones who are profiting from unfair advantages. Promising to create an exchange that attracts one but not the other “is a marketing ploy designed to capitalize on paranoia,” Narang says.
Many other market experts agree that the image of high-frequency traders as market manipulators is way overblown. Still, if IEX makes ordinary investors even a little more confident in the workings of the market, that alone could be a good thing for the economy. People have always worried that the market isn’t fair, but as high-frequency trading took off, those worries only seemed to increase. The share of Americans who own stocks has fallen for five straight years, according to Gallup, and just hit a 15-year low, even as the market has reached record highs. People scared away by a market that seems unfair or incomprehensible are missing out on those tremendous gains. “It should be a given that the markets work,” Katsuyama says. “The fact that they don’t is the opportunity we saw and why we started the company.”
Jacob Goldstein is a reporter for NPR’s “Planet Money,” a podcast and blog. Adam Davidson is off this week.
August 1, 2012
N.Y.S.E. Halts Some Trading After Irregular Price Swings
By NATHANIEL POPPER
United States stock markets were thrown into turmoil on Wednesday morning after more than 100 stocks were hit with a surge of volatile and unexpected trading immediately after markets opened.
The New York Stock Exchange said later in the morning that it was reviewing “irregular trading” that occurred soon after the 9:30 a.m. opening bell in 148 stocks listed on the exchange. Many of the nation’s most popular stocks were among those that saw extreme price swings, including Citigroup, Bank of America and American Airlines.
Traders immediately pointed fingers at one of Wall Street’s most powerful brokerage firms, Knight Capital Group, speculating that a “rogue algorithm” kept buying or selling millions of shares of companies for 30 minutes, sending their shares soaring or plunging. The Jersey City-based company said in a statement that “a technology issue occurred” in the division of the company that uses computer algorithms to buy and sell stocks from other market participants.
As Knight, one of the biggest market makers in the United States financial markets, rushed to contain the problem, it asked customers to send trades to other brokers. Knight’s stock dropped nearly 25 percent on Wednesday morning.
The event draws renewed attention to the increasing fragility of the United States stock markets as they have grown more fragmented and reliant on high-speed-trading firms like Knight. The volatility recalled the so-called flash crash of May 6, 2010, when the entire American market dropped nearly 10 percent in about a quarter of an hour.
On that occasion, stocks recovered from their most extreme losses but still finished down sharply. That event has been blamed in part for the increasing flow of money out of American markets and the waning confidence of investors. The turbulent trading on Wednesday morning did not have the same impact on the broader market as the flash crash, and the benchmark Standard & Poor’s 500-index was trading up 0.3 percent at midday on Wednesday.
The trading problems took place on the same morning that the New York Stock Exchange introduced a new program, the Retail Liquidity Program, that is set to bring it into competition with Knight for orders from retail investors. The program created a platform where orders from ordinary investors to buy and sell shares can be sent to receive a slightly better price than the publicly listed price. The exchange faced strident opposition from Knight and other market participants, which complained that the program would make markets less transparent, but regulators decided to allow it last month.
There was no immediate information from Knight or the exchange on whether the Retail Liquidity Program played a role in the morning’s problems, but Matthew Heinz, an analyst at Stifel Nicholaus wrote a note to clients in which he said that the program “could have something to do with today’s confusion as market participants adjust to the new order types and routing methods.”