Finance industry

Wall Street’s high-tech war on investors

A PC can be an investor’s best tool. But as a vast high-tech arms race unfolds, big brokers and hedge funds are using their computers to take unfair advantage.

MSN Money

PCs, broadband Internet connections, online brokerage accounts. These advances brought democracy to Wall Street, leveling the playing field between everyday investors and the insiders, right?

Wrong.

In fact, computers are ruining investing for the average investor.

Sure, your PC lets you see when your stock is moving. But multiply its computing power by thousands, add a throng of software geniuses earning more than $1 million a year and an army of full-time analysts, and you start to understand how the biggest brokerages and hedge funds can stay a few steps ahead of any move you can make.

Yes, you can trade from your cell phone while waiting at a traffic light. But at the big hedge funds, computers execute thousands of trades in milliseconds —and cut into line ahead of buyers like you and me, our mutual funds and our brokers.

All this helps explain why your portfolio was likely hemorrhaging money as stock markets tanked in the first quarter of this year — yet elite traders at Goldman Sachs (GS, news, msgs) were creating near-record profits.

Tricks of the trading

You won’t be surprised that your home computer pales compared to systems honed by the Wall Street elite at places like Goldman Sachs, Citadel Investment Group and Renaissance Technologies. But you might be surprised at what they do with those systems to get an edge over you:

  • Scour the markets for opportunities and make millions of trades in less time than it takes you to hit the "enter" key.
  • Take advantage of exclusive "flash orders" to trade stocks at better prices than you’ll ever see.
  • Fish for profitable stock bargains inside exclusive trading venues called "dark pools," where you’ll never swim.

The scope of this activity might also surprise you. Over half of all trades are done by Wall Street insiders using quick-fire trading systems; 7% of all trading is done inside secretive dark pools. "The public is getting screwed here," says one hedge fund manager who follows these developments closely.

Even if you’re not trying to be an active trader, these high-tech gunslingers impact the stocks you own and the mutual funds in your 401k. And, of course, we all get hurt if their rapid-fire trading systems spark a quick sector or market meltdown -– a real possibility, according to several analysts.

Here’s a look at just three of the tech tricks that make life tougher than ever for the average investor.

1. High-frequency trading

In high-frequency trading, or HFT, computers use sophisticated algorithms to hunt down opportunities all but invisible to the average investor. They spot a fleeting price or complex combination of trades, then lock in gains with a series of moves made at a clip that only a high-speed computer could pull off.

The race for speed is incredibly serious. Investment shops like Goldman Sachs compete to place their trading computers as close as physically possible to stock-exchange computers to make trades an instant faster.

HFT systems make tiny amounts of money per trade, so they have to do millions of trades to earn big bucks. It can seem like a good thing because HFT theoretically exploits only "inefficiencies" in the market — and no one likes inefficiencies.

Besides Goldman, Citadel and Renaissance, smaller shops like Getco, Jane Street Capital, Hudson River Trading, Wolverine Trading and Jump Trading also play this game. None of them cater to the average investor. Mutual funds and money managers investing for the long term, on the other hand, don’t generally use HFT because they typically have to stay in the market while building — or moving out of — positions. HFT trading systems generally unwind positions so they have no market exposure by the end of the day.

Here’s one big way all this hurts the little guy:

HFT computers can detect large buy orders for a stock, the kind of buy orders mutual funds make, even when the funds try to disguise them. The HTF system can then purchase that stock before the mutual fund’s order is executed. The fund ends up paying more per share, and the HTF traders pocket the difference.

This isn’t illegal; it’s akin to cutting into a long line at the supermarket. And it’s just as infuriating. "It just ticks off mutual fund managers who feel their stock moves against them every time they show up," says Al Berkeley, chairman of Pipeline Trading Systems, a trading service designed to help institutions and brokers outsmart HFT systems that try to detect their orders.

How much does all of this cost mutual funds in higher stock prices, or lower prices when they sell? It’s not clear, but one study by the Tabb Group estimates that high-frequency traders made about $21 billion in profits last year — much of that at the expense of mutual funds.

HFT systems have their defenders. If traders can use technology to figure out when mutual funds bumble into the market with a big order, they deserve to profit from it, say analysts at Zero Hedge, a Web site for hard-core finance and investing types. That’s another way of saying that mutual funds can fight back with their own technology or pay an outfit like Pipeline Trading to do it for them. "We use the same weapons that high-frequency traders are using, against them," says Berkeley. "We are arms merchants."

But remember: It’s fund customers like you and me who will pay the tab.

2. Flash orders

High-frequency trading sounds even more unfair when it’s used with a more controversial high-tech trick, the "flash order" — the quick display of unfilled trading orders to a select few insiders.

Flash orders exist because, over the past few years, upstart stock exchanges like Direct Edge and BATS Exchange have cropped up to do battle with traditional outfits like the New York Stock Exchange and Nasdaq ($COMPX). To win trading volume, the upstarts had to offer big customers something to get their business. Enter the flash order.

Smaller exchanges have to pass along big orders to the big exchanges if it looks like they can’t fill them. To avoid this loss, they "flash" these orders to big customers for less than half a second. The hope is that big players will help fill the order, splitting the fees with the small exchange.

But this also gives the insider an advance look at a trading price you and I never see. Mind you, it’s a half-second advantage; you and I couldn’t do anything with it anyway. But those with HFT systems can.

"The vast majority of the trading world has no way to capitalize on this, absent substantial (capital) investments to the tune of tens of millions of dollars," say analysts at Zero Hedge.

Here’s another thing about flash orders that doesn’t seem fair. By pinging most of the market every few milliseconds, a good HFT system can sense overall supply and demand for a stock. When it sees a flash order to buy a stock for which it knows there’s limited supply, it’ll go out and sop up all the available stock ahead of that order. It can then resell the stock quickly for a profit.

"They know about the order and can beat everyone to the stock because they have a faster system," says one hedge fund manager. "They front-run and drive the price up ahead of everyone else. Anybody buying stock is getting screwed, from the big mutual funds to the smallest guy buying 100 shares."

After The New York Times and The Wall Street Journal broke stories on flash orders and other electronic trading just a few weeks ago, the Securities and Exchange Commission said it would crack down on such orders and investigate related issues. Direct Edge, BATS Exchange — and the Nasdaq, which has also offered flash orders — all say they will stop providing them soon.

But given how profitable they are for the biggest traders, we’ll have to wait and see how this plays out.

3. Dark pools

Technology gives privileged insiders an edge in another way — by connecting big players inside exclusive electronic trading venues. Because they are private and trading is anonymous, these secretive venues are known as "dark pools."

Inside dark pools — like one called "Sigma X" run by Goldman Sachs and another run by Investment Technology Group — huge amounts of stock are bought and sold every day at prices that outsiders may know nothing about until well after the fact.

This gives big players two advantages: lower fees on the actual trades and secrecy. When you’re making big moves, you don’t want competitors to notice what you’re doing.

This creates two problems for the rest of us. First, these trades affect the value of stocks you and I own, but they’re invisible to those outside the dark-pool set. "They create a very unfair playing field," says Richard Olsen, the chairman of OANDA, a currency trading platform.

Second, if enough trades move to dark pools, they will undermine the significance of publicly available prices on the regular exchanges. That’s bad for the economy, because reliable stock prices are supposed to help guide investment dollars to the most deserving entrepreneurs.

In June, more than 7% of all trades happened inside dark pools, according to Rosenblatt Securities. Is that enough to undermine the public markets? The SEC says it’s trying to figure that out. But since the SEC is outmatched and outgunned technologically, you have to wonder if it will do any better a job here than it did investigating Bernie Madoff.

The big meltdown risk

Overhanging this rapid-fire environment is the risk it could create a serious market meltdown by accident. HFT systems trade huge volumes at stunning speeds, and that’s a recipe for potential disaster, believes James Angel, professor of finance at Georgetown University’s McDonough School of Business. There’s no way humans can screen for errors.

"We have no real-time circuit breakers for our nanosecond market," he says. "Our markets are dangerously unprotected from when somebody’s algorithm misfires."

If you think it can’t happen, remember the October 1987 market crash that included Black Monday, when the Dow and S&P 500 each lost 20% of their value.

The quick plunge occurred in part because so many investors relied on the same sort of algorithms computer trading systems use to sell off part of a portfolio after a certain level of losses.

Today, the meltdown risk is compounded because high-frequency traders deliberately probe across various markets — from currencies to bonds and commodities — in exchanges around the world. So a meltdown in one market could quickly spread to another, and existing protections like those on the NYSE could never keep up.

This doesn’t mean we should ban high-frequency trading. As former SEC Chairman Arthur Levitt points out, high-frequency trading also helps everyone by adding liquidity to the market, making it easier to buy and sell stocks.

But Angel and others argue for better automatic circuit breakers that kick in when stocks or markets move quickly by a preset amount, to avoid the meltdown scenario. "Our regulators are being seriously negligent by ignoring this risk," he says.

Indeed, regulators missed Madoff and the excessive use of leverage and complex debt instruments that contributed to the mortgage meltdown we’re still suffering from. It’s hard to believe they’ll protect us from this danger.

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