Of Course The Market Is Rigged!

Includes: DIA, IWM, QQQ, SPY
by: Lawrence Fuller


High-frequency trading (HFT) is the most dominant and manipulative force in our markets today.

Its impact poses significant risks to market structure and investor psychology.

Practical solutions that address these risks will ultimately come from the free market.

Expect significant market volatility and a reversal of the upward bias HFT has had on stock prices as its influence wanes.

The stock market is one of the most critical components of our free-market economy. Its purpose is to allow companies the opportunity to raise capital and to allow the public the opportunity to create wealth by owning pieces of these companies.

High-frequency trading (HFT) serves absolutely no purpose in meeting either of these ends. Instead, it is one of the most pervasive deceptions on Wall Street, generating profits through a manipulative form of financial engineering that capitalizes on technological advancements that were intended to benefit the investing public. HFT serves no one but its purveyors, and it does so at the expense of the investing public. It is a parasite, and we are its hosts. It is a cancer that continues to slowly erode the faith that the public has in our financial markets. Given its size and scope, it is one of the most prolific forms of Wall Street thievery, and it needs to be abolished in its current form at once.

The complexity of HFT enhances its obscurity, which has enabled it to grow tremendously since the late 1990s into what is the most dominant and manipulative force in our financial markets today. Despite repeated warnings from industry insiders and a series of events over the past five years that have blatantly exposed the systemic risk posed by the practice, legislators and regulators have done nothing to address the issue. Then 60 Minutes aired a segment about Michael Lewis's new book, Flash Boys: A Wall Street Revolt, which exposes the dark side of high-frequency trading, and the swift hands of justice were miraculously on the move. The very next day the FBI announced that a year-long investigation was underway to look into the legality of HFT. The day after that the SEC informed the public that it has ongoing probes into the matter, assuring us that it is upholding its stated mission to "protect investors" and "maintain fair, orderly, and efficient markets." By the end of the week, the always vigilant Department of Justice, led by Attorney General Eric Holder, decided to join the party with an investigation of its own to determine if HFT constitutes insider trading.

While it is good to know that our Keystone cops are finally on the beat, the reality is that this virus has already consumed its host. It is no longer feeding on the market, because it has become the market, which means it can no longer be abruptly extinguished as it should have been a long time ago. The best possible outcome is that the abusive, if not illegal, practices are rooted out for all to see, so that public pressure forces regulators and legislators to act. Fortunately, the more reliable forces of the free market are already in motion, exposing the manipulation and developing solutions that will hopefully starve HFT firms of their illicit profiteering, but the issue of systemic risk remains.

The invisible hand

I first noticed that something was amiss with the stock market during the months that followed the financial crisis in 2009, but I couldn't explain it. Having spent 20 years watching market indices and stock prices gyrate on computer screens all day, it was clear at that time that something was crooked, and it was becoming more pronounced as the market recovery wore on.

When I placed a limit order to buy or sell an individual stock, ETF or option contract, the size (number of shares or contracts) shown as available to buy or sell at the bid or asking price would disappear as soon as I hit the send button. Basically, the stock would move away from my limit, forcing me to change my price if I wanted to be filled. If I let my order stand, sometimes I would get filled, but other times I would not. If I adjusted my order to the new bid or asking price, sometimes I would get filled, but other times the size would vanish again, forcing me to make yet another adjustment. It was a recurring annoyance for which I had no explanation, other than feeling like some invisible hand was intentionally screwing with my order.

The activity in the broad indices was also suspect. A chart of the S&P 500 (NYSEARCA:SPY) over several weeks or months might look normal, but the intraday action was anything but normal. The S&P 500 could spend hours within a two-point trading range, as though being held motionless by the same invisible hand that had manipulated my order earlier that day, then suddenly move up rapidly by five, seven, even ten points on no notable news at all. The index would also make sudden significant moves, typically upward, at similar times each day, such as 10:45 am EST or at exactly 2pm and 3 pm EST. This is a common occurrence to this day. Then the "flash crash" hit on May 6 2010, when the market abruptly plunged around 2:30pm in the afternoon, recovering nearly everything that it had lost before the closing bell.

Thereafter, I began to gather all the information I could find on the subject of high-frequency trading. A lot of what I read I didn't understand. It didn't have anything to do with finance or investing. What I did learn was that our stock market had been systematically hijacked by computer programs that were trolling the numerous electronic trading venues for information about buy and sell orders, placing and canceling billions of their own orders at unfathomable speeds, all in an effort to earn a fraction of a penny in profit on each trade. I had experienced the frustration of having to navigate around the SOES bandits in the mid-1990s with respect to the technology stocks that I bought and sold, but these were human beings that were day-trading, and while they were capitalizing on the advancements in electronic trading, they could lose money just as easily as they made it.

The origins of HFT

In order to understand what's wrong with our market structure today and why the claims made by the various agents of high-frequency trading are false, it helps to understand what the market structure used to be like some 15 years ago and how it has evolved.

During the 1990s, if you bought a stock that was listed on the New York Stock Exchange, your order would be sent by your broker to a specialist that was assigned to that stock on the floor of the exchange for execution. The specialist, as a market maker, would handle the order flow in specific stocks, matching buyers and sellers, as well as trade with his or his firm's own capital along with those orders. The exchange would grade specialists on their stabilization record, requiring them to trade against the trend, and based on these records they would be awarded new stocks. If you bought or sold a stock on the NASDAQ, which was an electronic market, your order would be executed based on the best available bid and offer posted by multiple market makers, otherwise known as dealers. In both cases, the market makers provided liquidity to the market with the bids and offers that they posted.

Technological advancements led to the emergence of electronic communication networks (ECN) that initially allowed institutional investors to transact buy and sell orders directly with each other, bypassing the exchanges. The first of these ECNs was Instinet. Instinet served as an electronic brokerage firm for institutional investors who wanted to trade directly with each other at better prices than those they saw on the exchanges, and at a very low cost. The first high-frequency traders (HFTs) were eventually allowed to trade on networks like Instinet. As the number of ECNs grew, so did the competition for orders. The ECNs competed for the substantial HFT order volume by giving the HFTs access to all of the information about their institutional clients' orders. The HFT computer programs could then trade and profit on this order flow data.

The SEC worried that institutions (not HFTs) were obtaining better prices on ECNs than retail investors were obtaining on exchanges. Regulation ATS (Alternative Trading System) was implemented in 1999, in part to address this concern. It made ECN orders transparent to the public, which resulted in narrowing the spread between bid and asking prices. It essentially commoditized the pricing mechanism.

Then the SEC implemented Regulation NMS (National Market System) in 2007, which aggregated the best bid and offering prices on all exchanges and ECNs, resulting in one national best bid and offering price for a stock (NBBO). If an ECN or exchange held an order but did not have the best matching bid and offering price, it would have to route that order to another venue to obtain them. That commoditized the various trading venues. It also led to the demise of the NYSE specialist system, forcing the NYSE to convert to an electronic exchange, which is why the floor is now empty when you see it on television.

The increase in the number of ECNs and exchanges, along with the commoditization of pricing and trading venues, the gradual narrowing of spreads from fractions to pennies, and the surge in execution speeds were all tremendously beneficial to individual investors. At the same time, these developments led to an enormous increase in the size and fertility of the feeding grounds for high-frequency traders. While the benefits are transparent, the costs incurred as a result of the explosion in HFT are not. While much has been made over the past week of the one-penny profit, or fraction thereof, that these algorithmic trading programs seek to obtain on each trade, I am far more concerned about the systemic risk that this voluminous force presents and the damage it is causing to the credibility of our market structure.

HFT tactics

HFT firms begin and end every day in cash. They often employ leverage that would have made Lehman Brothers proud. The proprietary algorithmic trading programs that are the core of their businesses, which have investment time horizons measured in milliseconds (literally) and trade hundreds of millions of shares a day, could care less about what happened yesterday, or what might happen tomorrow. They are indifferent to what it is that they are trading, so long as it has a symbol and a price. Their business model is based on influencing and reacting to the buy and sell orders of other market participants.

HFT firms pay to locate their servers next to the servers owned and operated by the exchanges and ECNs (co-location) in order to gain a speed advantage in accessing order flow information and routing their own trades. One of my favorite quotes about order flow comes from Andrew Van Hise, who designed the algorithmic trading program for Steven Cohen's SAC Capital hedge fund. He said that HFTs treat retail orders like tip sheets to be harvested and discarded, and that once "a standard retail or institutional order reaches an exchange, it has been looked at in essence by a number of algorithms which have cherry picked it."

As if that were not enough, HFT firms even pay research firms and news organizations for the early release of market moving economic data and news reports. Reuters was forced to suspend its practice of selling access to the University of Michigan's consumer-sentiment report to HFT firms before anyone else had the report last summer. Why not just let these HFTs buy access to quarterly corporate earnings reports a few minutes before everyone else as well? What's the difference?

There are numerous trading tactics employed by HFT firms. Some of these tactics are referred to as layering, quote stuffing, exploratory trading and order book fade. They sound like plays a pro football team might run. The common thread in these tactics is that they all involve sending, and in some cases flooding, an exchange or ECN with orders to buy and/or sell that they then cancel milliseconds later to give the impression of demand and/or supply that does not really exist. The intent is to manipulate prices and the actions of others in their favor. The evidence of this is in their order cancellation rates, which are as high as 98%. The SEC considered charging fees for the order cancellations to combat the manipulation back in 2012, but nothing ever transpired, partly due to the misconception that high-frequency traders provided liquidity to the markets.

The markets are rigged

That the markets are rigged is an assertion that has really put the HFT industry on the defensive, and for good reason-it is the ugly truth that could put them out of business. "Rigged" implies manipulation in a fraudulent manner. When an HFT firm is showering an exchange with quotes to buy and sell securities, but it never has any intention of honoring those offers to buy or sell, considering that 95-98% of those quotes are immediately cancelled, then it is doing so to manipulate supply and demand (stock prices) in such a way that it can profit from it in a deceitful manner. That sounds like fraud to me.

It also sounds like the HFT business model is violating the fairness principle. Daniel M. Hawke, chief of the SEC's enforcement division's market abuse unit stated in September 2012 that "the fairness principle that underlies the foundation of our markets demands that prices of securities accurately reflect a genuine supply of and demand for those securities."

When an HFT investment firm like Virtu Financial discloses that it lost money on just one trading day over the past five years, it is obvious that its activities have nothing to do with trading or investing. It is doing something that guarantees it will make a profit nearly every single day with respect to the securities that it is buying and selling. Therefore, with respect to the market in which it is trading, it has rigged it in such a way (in this case with an algorithmic trading program) as to guarantee a profit. Taken a step further, since HFT firms like Virtu account for the majority of trading volume on the exchanges, and nearly all of the quote volume, one could then conclude that the markets are rigged in their favor.

The benefits of HFT

The HFT industry validates its existence by claiming that it provides markets with liquidity and that its activities have further narrowed spreads, thereby lowering costs for individual investors. Neither is true.

HFTs often compare themselves to market makers when they explain how they provide liquidity to the market. The problem with this comparison is that a market maker, like the specialists that used to stand on the floor of the NYSE, had responsibilities. They had to post a bid and offer for their stock at all times and honor those bids and offers. HFTs do neither. In fact, the evidence shows that their bids and offers are nothing more than fake and manipulative quotes.

There is also no proof that HFT trading volume narrows spreads. An academic study by Watson, Van Ness and Van Ness in 2012 showed that the spread between bid and asking prices in US stocks from 2001-2005 was an average of 2.2 cents. During the time frame when HFT trading activity became more than 50% of the overall trading volume (2006-2010), the spread actually widened to 2.7 cents.

The risks posed by HFT

If our brightest mathematical minds want to write code that pinches pennies for a living, turning our financial markets into a rigged casino, it is shameful. It is an embarrassing waste of an education, but I am told it is a very good living. I suppose I could live with a situation where every time a trade is placed, it must pass through a one-cent toll booth on its way to execution. It may be unethical and wrong, but so are a lot of things on Wall Street that will never change.

The pennies that HFTs earn, which add up to billions on an annualized basis, have received most of the attention during the heated debate in recent days, but this is just a cost that investors incur. It is the risks that HFT presents, rather than the costs, which concern me the most-one is structural and the other psychological.

Having grown in size to account for the majority of trading volume, all of which has a time horizon of a millisecond, there is no individual or institutional force that can counter the influence of high-frequency trading. Since the flash crash in 2010, we have seen numerous instances of extreme market volatility. BATS Global Markets, an exchange at the epicenter of HFT, botched its own IPO in 2012 when what was surmised by many as rogue algorithmic programs sent its stock price from $15 to a few pennies on the first day of trading. It was forced to withdraw its IPO. A few months later, Knight Capital Group lost $440 million in less than an hour when one of its own programs went rogue, sending one of the largest electronic brokers by share volume at that time to the verge of bankruptcy. Even an erroneous tweet about an explosion at the White House can send markets reeling, as one did last April.

What hasn't been discussed is when these so-called market makers decide to move to the sidelines en masse for an extended period of time, rather than for just a few minutes. My research has led me to the conclusion that HFT tactics greatly accentuate the underlying direction of the broad market, which has been consistently upward since the summer of 2012 on the tailcoats of relentless quantitative easing. Now some of the monetary policy dynamics are changing. Since HFTs have been allowed to grow in size and influence to account for the majority of trading volume, what happens to market liquidity if, and when, the high-frequency traders step aside, or worse yet, shut down? The HFT glue that is holding together our warped market structure will melt away.

As I write this article, I am watching the NASDAQ cascade by more than 3% (Thursday afternoon). I find it very interesting that the recent market decline, with the exception of yesterday's Fed-induced bounce, began last Friday, immediately following Attorney General Eric Holder's announcement that the Department of Justice had opened an investigation into whether or not HFT violated insider trading laws. Coincidence or not? It sure seems like there is a sudden lack of liquidity in the stock market. Could the high-frequency traders be reining in their activity? I think it is the lack of liquidity that has been responsible for the significant melt up in stock prices over the past 18+ months, but a lack of liquidity cuts both ways. A sharp and disorderly decline in the broad stock market is what I see as the greatest risk due to our HFT-focused market structure. This will surely further damage investor psychology.

If the stock market is still the bridge between Wall Street and Main Street that it was originally intended to be, then that bridge is on the verge of collapsing. We often hear about how the latest Wall Street scandal or electronic market malfunction damages investor confidence, but what is far more important is the faith and trust that investors have in the stock market system itself, because without the faith and trust of investors, the system will not work long term. I think that is the direction we are headed towards today. Solutions are desperately needed to address these risks.


I understand why those affiliated with the news services, brokerage firms, investment banks and various trading venues that benefit financially from HFT remain silent with respect to its manipulative influences and structural risks. What I don't understand is the passive commentary from many, if not the majority, of financial professionals, firms and journalists unaffiliated with HFT. There should be a collective uproar and outrage. Instead, I read and hear about how HFT isn't that big a deal for long-term investors.

Vanguard Group recently stated that they believe "a majority of 'high-frequency traders,' which is not a defined term, add value to our current structure by 'knitting' together today's fragmented market centers." Vanguard is a part of the problem. I think they are fearful, like many others that earn fees on the assets they have under management, that if they suggest that the market is rigged in any way, they run the risk of losing embittered clients, customers and assets. Yet this is the type of short-term thinking that epitomizes the HFT industry.

There have been many practical recommendations on how to control HFT, yet none is likely to materialize. They include charging HFTs for their cancelled orders, disallowing the fee rebates paid by exchanges to HFTs for directing order flow to them, and preventing HFTs from obtaining market-moving information and order-flow data before the public. I think the most logical solution would be to force these self-proclaimed market makers to uphold the bid and asking prices they post for a security for one second. It is also not likely to happen, but it would bring an end to the manipulation, or the perception thereof.

What we will see soon enough are televised congressional hearings, during which our legislators will pander to the public, hauling in a handful of experts on both sides of the issue to ask questions about things they don't understand, and don't intend to learn about, so as to give the appearance that they are doing something other than campaigning for the mid-term elections.

As for our regulators, I think they will have a difficult time finding the evidence of chicanery they seem to require in order to take meaningful action, considering that they have procured the technology necessary to monitor HFT market activity from the HFT industry itself. The recent blog post by Themis Trading, which connects the dots between the SEC's Midas system and the HFT insiders that it is supposed to be monitoring is absolutely stunning.

In an effort to practice what I have preached, I intend to do my part. I intend to send a letter to TD Ameritrade (NASDAQ:AMTD), which serves as my discount broker, in which I will ask them to end their practice of paying for order flow. Most discount brokers sell their orders to wholesalers that can then trade against those orders, and some of these wholesalers are inevitably HFTs.

The most likely, and perhaps best, solution to the HFT conundrum is the free market. Thankfully, it is in motion. IEX is a new alternative trading system, featured in the recent 60 Minutes segment, that is intentionally slowing down its order-routing process in order to nullify predatory HFT tactics. Interactive Brokers was recently the first online discount broker to give its customers the option of sending their orders directly to IEX for execution. I don't have enough information about IEX to know if this is a viable solution or not, but it is a start.

Investment strategy implications

The fact that our market is now dominated by algorithmic trading programs with ultra-short time horizons that race to react to things that have already happened, as opposed to positioning investments for things yet to come, has destroyed the market's discounting mechanism. Astute investors have depended on this mechanism for decades. We used to think of the market as being supremely intelligent from this standpoint, as a collective vote of all its participants on what to expect moving forward. That concept is dead, and it has investment strategy implications.

In other words, our stock market is no longer the leading indicator it used to be. I think this is one reason why some of us see a dislocation between the stock market and the underlying economy. There is no disputing that corporate earnings have risen substantially since the financial crisis, supporting the rise in equity prices, but the increase in confidence levels that historically accompanies the expansion in multiples as earnings and revenue growth rates have slowed has not materialized. I think HFT is a factor in this disparity, along with the speculative investment flows indirectly resulting from quantitative easing.

We must prepare ourselves and our portfolios for much higher levels of market volatility in terms of higher highs and lower lows as a result of the HFT phenomenon. I suspect that we have only seen the upside of its manipulative effects on market performance, which is the main reason it has been allowed to grow into such a dominant force.

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. Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Clients of Fuller Asset Management may hold positions in the securities mentioned in this article. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.