The Flash Boys Have It Wrong - The Market Is Not Rigged

Includes: SPY, XLF
by: Pat Stout


Speed advantage to the HFT - so what. Someone will always have a speed advantage.

Arbitrage is good. The examples in Flash Boys appear to be arbitrage related.

Econ 101 - supply and demand curve. Try to buy 100,000 shares with 10,000 offered then expect the market to re-price.

Unfair advantage, oh really? Who determines what is fair?

Unintended consequences. Could investors be facing wider spreads and higher costs?

Recently, high frequency trading (HFT) has gotten a fair amount of press. There was a 60-Minute story with the Flash Boys author. In case you are not aware, Flash Boys is book about HFT. CNBC had a segment with the Flash Boys author and the founder of a new dark pool IEX. The CNBC segment and the book were entertaining. Their conclusion that the financial markets are rigged is wrong, in my opinion. The financial markets may be confusing, frustrating and fragmented but they are not rigged.

Speed Advantage:

One argument was that HFT have a speed advantage. What if they do. They risked and invested hard-earned funds to build the code, buy the bandwidth, and invested in state of the art computer systems. They should be permitted a chance to earn a return on the investment, right.

Who should determine what the "proper" speed should be? Should it be the large institutions set in their way and not wanting to invest in unproven state of the art technology? On the other hand, maybe the retail investor, some that may not access to high-speed internet access, should set it.

Should speculators be denied the opportunity to risk capital on an unproven technology or trading strategy? The capital markets help fund new life changing technology and healthcare treatments. Without risk capital, much of what is taken for granted today may never have been produced. I recall upgrading from a 300-baud to a 1200-baud modem as a major speed improvement.

The idea that having a speed advantage on public exchange could be considered insider trading is an interesting concept. That would beg the question - how could making an investment decision with public information be considered insider trading? However, transactions done within dark pools might be a different matter.

Economic progress requires investment. Investment requires the opportunity to earn a return. Look at the knee jerk market reaction after many major economic releases. Which group of investors benefits the most? Is it the investor that has their sell order taken when the market spikes higher and buy orders bids hit when the market spikes lower the longer-term winners, right? The short-term moves could be noise that benefit longer-term investors.


Basic economics 101 suggests that arbitrage helps markets become more efficient. Flash Boys makes a big deal out of "slow market" arbitrage. Say market A has a posted market of 80.00 bid 80.01 offer and market B is 80.00 bid 80.01 offer. There is no arbitrage opportunity.




Market A




Market B




Then a seller unloads a large order on market B with the market now 79.98 bid 79.99 offer.




Market A




Market B




An investor, in this case a HFT, takes (buys at) the offer at 79.99 on market B from a happy seller and sells to a happy buyer at 80.00 on market A. Why are the buyer and seller happy? They received the price they wanted. This was accomplished by the HFT engaged in arbitrage. The reward for taking the risk is a penny per share.

Arbitrage is good. Those that practice "deal arbitrage" provide investors a chance to sell stock before a merger takes place. The arbitrageur takes the risk that the terms of the deal may change or a deal is not completed or takes longer than anticipated. The so-called, "slow market" arbitrager takes a similar risk while earning far less per transaction. Every investor that wants to invest the time and money is free to enter the slow market arbitrage arena. It may not be as easy or profitable as some have made it out to be.

Supply and Demand

Basic economics talks about the supply and demand curves. The greater the demand relative to the supply of an item the higher the price may go. The greater the supply relative to the demand of an item the lower the price may go. The transaction price at a point is time will be the clearing or equilibrium price.

Say an investor wants to buy 100,000 shares of a stock. Four exchange centers display the price and quantity available. The offer on market A is 1,000, market B has 49,000 shares, market C has 40,000 shares and market D has 20,000 shares all offering stock at 60.00. Dark pools do not display information to the rest of the market, such as the price and quantity available to buy or sell. One might argue that dark pools are making use of public trade data for their private benefit or have an unfair information advantage. There is a minor issue with the offered quantities shown. Market A could have 1,000,000 shares available for sale that were not displayed to the market, as only 1,000 were shown. By sending the entire 100,000 share order to market A for a fill with any unfilled shares then being routed to market B, then market C and finally to market D until the entire order is filled. The trade information is market information. Econ 101 would suggest that sending a 100,000-share order to an exchange showing 1,000 shares offered would suggest that demand exceeds supply requiring an upward price change or more willing sellers at that price. The financial markets are auction markets, so sellers of the stock on markets B, C & D may wish to test the market by increasing the price to help keep supply and demand in balance. This price change may result in no sale or it may result in a sale. If a sale occurs then the seller was previously underpricing the shares. If no sale takes place then the sellers priced themselves out of the market. What happens after a hurricane or major snowstorm - shortages appear. Speculators may rush to buy supplies they may not need, (plywood or salt), just in case. Then when more supplies are available, they return what was not needed. Those that were in dire need of the product and willing to pay more are denied the ability to do so. A retailer that increases prices of limited supply of goods to meet a surge in demand may be called a price gouger. In addition, the retailer may be made an example of in the press and or government officials. Is it fair that speculators can take product off the market and later return it without paying a price?

Unfair Advantage:

The investor with high-speed Internet access has a speed advantage over those investors that do not. An investor that lives or works near a financial exchange server has a speed advantage over those investors that do not. Decades ago, some investors were able to read the Barron's magazine over the weekend, while others had to wait until Monday or later in the week. Was that fair? Some investors had fax machines to see up to date charts, other investors did not have that luxury, was that fair?

The area where an unfair advantage could be argued is with the order entry options. If the order types are not available for use by every investors then that seems a tad unfair. Most investors may not use all the different order types but not having the option is not a level playing field.

Is it unfair that an IEX investor may have a company in a tax-advantaged nation? They may enjoy the benefits of the U.S. system without all the expense. It is legal and within the rules.

Is it unfair to retail investors that some large investors are given a chance to make investments in a firms capital structure that they are not offered the opportunity to invest in?

It is unfair that dark pools can make transactions in the dark or make use of public transaction data?

Unintended Consequences

Change to the current financial market practices could have large unintended consequences for traders and investors. For example, ETFs might find reduced liquidity to rebalance portfolio leading to increased fees thereby reducing investment return. The retail investor might face higher trading cost and commissions if there are changes in rebates. Order flow might change in unforeseen ways, like migrating offshore. The cost of news and data feeds may increase for all, except HFT as they currently pay top dollar. One might argue HFT permit the rest of investors to pay less for news and data feeds. Bid offer spreads may increase making it more expensive to trade. Each one-cent increase to the bid-offer spread on 4-million shares would increase the cost by $40,000.

There has been mention of a quote fee. To be fair the fee would apply to all investors. This could increase the cost for mutual funds and ETF's reducing the amount available for investment, and reduce investment performance.

The inter-market relationship between stock, bond, options, and currencies may be thrown out of balance with a hurried and not well thought out change to market rules or process.

Volatility could increase making the markets more trader friendly and less investor friendly.

Final Thoughts

Arbitrage is good for the financial markets, as it improves market efficiency. Should arbitrage be regulated then the financial market might look or act nothing like today's financial markets.

Issues in the Standard and Poor's 500 index (NYSEARCA:SPY) and especially the financial index (NYSEARCA:XLF) may undergo radical change and face untold headwinds should the financial market structure be further regulated because of some frowning on the arbitrage practice. The adjustment process of picking winners and losers may increase volatility. This could provide greater opportunity and reward to the arbitrageur.

Finding a way to reduce the number of phantom or non-tradable quotes and or prohibiting the cancellation of trades could go a long way to help reestablish trust in the financial markets. Why should a trader or investor place capital at risk if someone at an exchange can, after the fact, cancel a market or limit order? Mistakes happen and any trade issue should the parties to talk and work out a solution.

Bottom-line, investors need to take responsibility for the decision made. Moreover, attempting to buy or sell issues in quantities greater than displayed carries a risk and a cost. The U.S. financial markets are the best functioning markets in the world and any change should be well thought out and minor. Whatever is done will result in unintended consequences. Might it be better to trade or investor in the market with known limitations than to change the system introducing new and unknown limitations and issues?

The economy could be effected in countless and unexpected ways. Innovative investment in state of the art technology could decline as investors fear they may be denied the opportunity to earn a return. HFT traders have no protection like the drug makers. Employment in start-ups could be hindered as investors decide not to fund new unproven ideas and ventures. The private funding by Spread Networks created jobs. Jobs to build and design the network, maintain the network, improve the network, service the network, program the trade server, etc. Without the chance to profit from the investment, the jobs would not have been created. At last look, the US economy could use more jobs higher wage jobs like Spread Networks created.

It might appear that HFT has a minor impact on the economy. However, any change in regulation most likely will increase costs. Increased cost lead to lower profit margins and lower investment returns. This may hinder economic growth potential. Business attention may be diverted from growing the business to attempting to understand the impact of another regulation.

Investors have a very good deal in today's financial markets. It would be a shame if regulation resulted in increased bid-offer spreads. Higher commission costs by way of returning to a fixed commission schedule for all. Between wider spreads and fixed commissions, an investor might require a 5% to 10% move just to break-even.

To be successful traders need to adapt to what the market has to offer. The quick knee-jerk reaction of some HFT offers investors the ability to enter and exit positions at better than expected levels.

A number of issues that make up the SPY are owned and on occasion trades are made in SPY put and or call options. I have no current SPY position or its options.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.