By Ray Ryan, CFA
Ray Ryan is a Principal and Portfolio Manager of Patten and Patten, an investment management firm, and a Registered Investment Adviser in Chattanooga. Ray is a CFA Charter Holder, a member of the Advisory Board for UTC’s College of Business, and an Adjunct Professor of Finance at UTC. He is a graduate of Princeton University, where he had the privilege of taking a course taught by current Fed Chairman Ben Bernanke.
Full disclosure: I am a huge fan of Michael Lewis, and I have read all of his books. I have read some of them multiple times. He is the author of such bestsellers as Moneyball, The Blind Side, The Big Short, and Liar’s Poker. While I do not always agree with his point of view, his journalism is balanced and thorough.
But it made me wonder: What evidence does the book offer that the stock market is rigged? If it is indeed rigged, then who has rigged it? Who is being harmed and who benefits? Most importantly, what can be done about it?
These were just a few of the questions I had on my mind as I navigated my way through his book. Lewis does an excellent job explaining the technical side of the markets – i.e., rules for clearing trades and ensuring an orderly marketplace; technology that is necessary for rapid dissemination of reliable information to financial intermediaries and investors.
By way of background, it is important to appreciate that the stock market functions like all other markets. A market, after all, merely requires a buyer and a seller. In order for markets to function smoothly and on a large scale, there are additional requirements beyond the creation of a simple forum in which buyers engage sellers. Modern financial markets, for example, rely on liquidity, and they also rely on rules to ensure fairness.
Liquidity accelerates the process by which the equilibrium, or clearing price (i.e., the price at which supply equals demand) of an asset or commodity is discovered. For example, in a two person market, a clearing price can be difficult to realize absent additional participants. Thus, the more liquid markets tend to have a greater number of participants.
Each of the participants in a market, presumably seeking to maximize profits, must feel confident that the information they receive is accurate and reliable. Their actions (i.e., buying or selling), based on that information, tend to drive prices toward equilibrium. In order to ensure reliability, modern financial markets require rules that include penalties for unscrupulous, unethical, or fraudulent behavior.There are also rules that establish an orderly system for executing transactions. Buyers and sellers in any marketplace need to trust the infrastructure, and rules tend to be designed by the participants to preserve that trust. The modern financial markets have evolved over time with these basic principles firmly established.
Financial markets also depend on, though they do not require, the activity of intermediaries to facilitate the discovery of clearing prices. Often, these intermediaries provide liquidity, as the market occasionally lacks sufficient sellers for prospective buyers. It is well understood that intermediaries (and speculators that behave like intermediaries) have discovered methods of realizing profits for themselves in this process. Arbitrage is the term used to describe strategies designed to exploit pricing inefficiencies within and among markets. Provided these participants act within the rules, capitalizing on arbitrage remains a perfectly legal activity and often leads to improved efficiency in the markets. In a way, these intermediaries tend to actually improve liquidity.
Financial market microstructure is not bulletproof, and unscrupulous speculators, since the stock exchanges were founded, have managed to exploit loopholes and flaws, sometimes at the expense of unwitting participants. It is also well understood that regulations are incapable of keeping pace with technological innovation. As a matter of fact, most of the regulations that still govern the financial markets were written during the depths of the Great Depression and in response to the Crash of 1929.
Lewis identifies a “problem” that was seemingly created through technological innovation in the financial markets. In his book, he describes the development of ominous sounding structures known as “dark pools” and the ability to exploit pricing differentials through enhanced network connectivity (i.e., “high frequency trading” or HFT).
Most stock trading today no longer occurs on the floor of the stock exchange. Stock trades are now electronic transactions, often determined by computer algorithms that match orders. Television coverage of daily activity on the stock exchange floor has become a ceremonial vestige of a bygone era. An intermediary’s advantage is no longer based primarily on financial acumen but has become dependent on the distance and speed trade orders traveled. Short-term arbitrage strategies are now the domain of computer programmers that seek to automate transactions and eliminate fallacies typically associated with human interaction.
The problem, discovered by several market participants over time, was that pricing information was less reliable because of the activities of HFT firms and certain intermediaries. Mr. Lewis chronicled the efforts of several stock traders that grew frustrated by exploitation of the current infrastructure and consequently set out to build their own stock exchange.
It has been well known for some time that numerous financial firms invested billions of dollars in “co-location” and proximity of physical plant to electronic exchanges to improve speed of transactions and information acquisition.
Presenting an argument that seemed to be predicated on the notion that “where there is smoke, there must be fire,” Lewis asserts that there must be nefarious motivations given the magnitude of these investments. Relying primarily on anecdotal information, the book alleges that market makers, HFT firms, and speculators have found a way, perhaps beyond established rules, to earn significant profits through enormous investments in speed and technological capacity. However, since these financial intermediaries are not required to provide detailed disclosure related specifically to these activities, the book lacked definitive evidence as support.
Nevertheless and assuming Lewis is correct, I found it interesting that the competitive advantage of such investments, according to the book, is measured in milliseconds. One millisecond is equal to 1/1000th of a second. As a frame of reference, one blink of an eye is the equivalent of 100 milliseconds. It was, therefore, most curious to learn that these firms had invested billions to earn an advantage measured in milliseconds for pricing differentials that were typically about $0.01 per share, or less.
Is the stock market rigged? To the extent activities such as HFT have eroded the accuracy of price information in the stock market, large financial speculators whose strategies depend on rapidly trading large volumes of stock are understandably concerned about the integrity of the markets. For such participants, I suppose the market could seem rigged. However, for most investors with a long term horizon, milliseconds and fractions of a penny should not matter. When arbitrage opportunities are limited to such miniscule price inefficiencies, the market infrastructure must be more difficult to exploit than before. Lewis has clearly identified issues that must be addressed by the regulators, and in that regard, I welcome his book as a catalyst for positive change. Ironically, however, I now derive greater comfort about the integrity of the stock market.