Rigged Markets?

Before I start ranting about stock markets, first a disclaimer: I worked as a software engineer for BATS Global Markets for five years and left to pursue other interests last May. BATS runs stock and options exchanges in the US and Europe. My views on this subject are based on my experience working closely with the operations team in the trenches (tranches?) of market infrastructure. If you don’t nod-off before the end of this post, you can decide for yourself if my position is biased or informed.

There has been a media blitz surrounding a book released a few weeks ago titled: “Flash Boys: A Wall Street Revolt“. It claims the markets are rigged, the exchanges enable it, and hyper-speed traders and exchange operators are raking in millions skimming money from your grandmother’s nest-egg. How I wish it were so simple! The market is complex and imperfect, but it’s not rigged – Technically. Actually, I would argue it’s less rigged now than at any time in history, which I will try to do assuming I don’t get sidetracked.

For over 200 years the US stock markets ran in geographically independent locations like New York and Chicago. During this time the floor broker ruled the roost. Don’t live near the exchange? Too bad. Think about the arbitrage opportunities when the telephone was invented – it was the ultimate speed advantage! Over the last 30 or so years the conversion to an all electronic market structure in effect democratized stock trading. It made the practice both more affordable and geographically accessible to significantly more people. It also amplified the problems associated with having disparate liquidity sources.

In 2007 the SEC tried to address this messy market fragmentation with the National Market System, or “Reg NMS”. The idea was to duct tape all the trading venues into one big financial Rube Goldberg machine. Actually the idea was to provide fair and accurate pricing for participants while fostering competition between trading platforms. Unfortunately, Reg NMS managed to achieve both to a certain degree. Current US market structure is effective, but it’s a complicated web layered with intermediaries. On top of that the implementation of this regulatory behemoth has flaws (gasp). If a loophole exists on Wall Street, well, you can probably guess what happens.

Speed has always been an advantage in price-time priority based markets. The “rise of the machines” in stock trading has only refined this reality to a very precise degree. Exchanges are required to provide fair access to all participants, but this only extends to the edges of their network. Outside of that zone, firms can use all the resources at their disposal to gain any advantage possible. NEWS FLASH: the ones with the fattest wallets and biggest brains tend to do better. I believe it’s called capitalism.

Not all market participants are created equal – some have special roles that basically sanction skimming in exchange for providing liquidity, also known as “Market Makers“.  Like it or not they are an integral part of the ecosystem. Electronic market making can be consistently profitable, as evidenced by firms having only 1 losing trading day in 5 years. But the flip side of this is tremendous risk when things don’t go your way. Knight Capital found this out in 2012 when a software snafu cost them over 400 million bucks in less than an hour. Ouch!

The stock market is not fair, and it never was. In my not-so-humble opinion, it was never designed to be. Suggesting this is a new problem because the big bad machines are pinching grandma’s pennies may be nice for book sales, but it conveniently glosses over a couple hundred years of history that suggest otherwise. I see the market as a work in progress. Keep in mind I’m a software developer, so for me nothing is ever “done” (it’s a job security thing).

There needs to be an ongoing discussion about what works and what doesn’t, followed up with good faith efforts to fix inefficiencies. This happens between exchange operators and market regulators on a regular basis. It’s a tediously slow process, but it does happen. Using populist rhetoric to vilify a system you don’t completely understand is counter productive to advancing that discussion.

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