Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street Are Destroying Investor Confidence and Your Portfolio Hardcover – May 24 2012
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From the Back Cover
“Read this book before you invest a penny in the stock market.”
—Mark Cuban, Owner, Dallas Mavericks
“In one of the most memorable scenes in motion picture history, before giving him the red pill, Morpheus says to Neo, ‘You’re here because you know something. What you know, you can’t explain, but you feel it. You’ve felt it your entire life—that there’s something wrong with the world. You don’t know what it is, but it’s there, like a splinter in your mind, driving you mad.’ Although Arnuk and Saluzzi will not expose every dark corner of the ‘matrix’ that our capital markets have become, they will provide the clues to aid you in your quest to understanding just why more people withdraw from trading fully aware that ‘there’s something wrong.’ Morpheus also asks, ‘Do you want to know what it is?’ To all who answer yes and take the red pill, read this book.”
—Tyler Durden, Zero Hedge
“Markets now trade at the speed of light, apparently benefiting Wall Street ultra-short-term traders over long-term investors and causing more than a few ‘flash crashes’ along the way. Arnuk and Saluzzi intuitively piece together how High Frequency Trading, for-profit exchanges, fragmentation, regulatory changes, and a ‘need for speed’ over the past 20 years have dramatically shifted benefits from investors to short-term traders in our increasingly fragile markets. A must read for anyone concerned about investors, trading, and the long-term health of U.S. stock markets.”
—Professor Michael Goldstein, Professor, Finance, Babson College
“Arnuk and Saluzzi are the Woodward and Bernstein of the securities markets. Their gutsy, dogged sleuthing exposed the perverse market effects of robotic trading and predicted an event like the Flash Crash 2010, long before blinkered market regulators had a clue. The two crusaders deserve a medal for looking out for investors.”
—Jim McTague, Washington Editor, Barron’s
“Who broke the stock market? The NYSE and NASDAQ, that’s who. They sold the investing public down the river so colocated algo driven servers of high frequency traders could steal billions by front running grandma’s mutual fund. The horrific truth about this legalized theft is all here in black and white. Read it, and you will never so much as invest one thin dime in U.S. equities again.”
—Barry Ritholtz, CEO, FusionIQ; Author, Bailout Nation and The Big Picture website; Bloomberg personality
“The authors explain in wonderfully clear language how, instead of banning card counters as they do in Vegas, Wall Street has remade itself to not only stack the deck in the card counters’ favor, but to enable them to do so via ever-faster computer networks and algorithms, that leave not only ordinary investors but many sizable institutions, like pension funds, with worse odds than on a lottery ticket. There’s more, much more, in Arnuk and Saluzzi’s book; it’s quite simply a must read, if you care about your capital—or the future of our capitalist economy.”
—Kate Welling, Former Founder, Editor, and Publisher, Weeden & Co. LP, Welling@Weeden; Former Managing Editor, Barron’s
An eye-opening view on the way stocks are really traded today—and why the stock markets are broken and desperately need to be fixed. Written in an easily understandable style, the authors explain:
• The strategies and tactics high frequency traders use to scalp pennies off of nearly every retail and institutional share traded
• How the stock exchanges provides high frequency traders with powerful tools that give them an advantage over retail and institutional investors
• Why the stock markets no longer accurately price the values of the securities in your portfolio
• What you can do to prevent these and other problems from getting any worse
Authored by the Wall Street traders who figured out how high frequency traders were harming retail and institutional investors and explained how it all works on 60 Minutes, Bloomberg TV, CNBC, and Fox Business News
• Why retail investors are pulling their money out of stocks in unprecedented amounts
• How decades of regulation created the broken markets we have today
• Why there are more than 40 exchanges, sub-exchanges, and dark pools rife with conflicts of interest where stocks are traded today
• How the stock exchanges became for-profit companies and fundamentally changed market structure
• Why the Flash Crash happened—and why it will happen again
• How there are two markets—the fast, accurate one that high frequency traders see and the slower one that retail and institutional investors see
About the Author
Sal Arnuk is partner, cofounder, and co-head of equity trading of Themis Trading, LLC, a leading independent agency brokerage firm that trades equities for institutional money managers and hedge funds. Arnuk has extensive experience in equities trading and is an expert in electronic trading and market structure. Prior to founding Themis in 2002, he was with Instinet Corporation, where he headed the team responsible for equity sales and trading for institutional money managers, for more than 10 years.
His opinions are sought by leaders, regulators, market partici-pants, and the media and are presented via white papers and Themis’ widely read blog. He is a frequent speaker at industry conferences, such as Trader Forum, Waters, National Organization of Investment Professionals (NOIP), and Fusion IQ’s Big Picture, on issues involving market access, algorithmic trading, and other sell- and buy-side concerns.
He also provides expert commentary for media outlets such as the Associated Press, BBC Radio, Bloomberg TV and Radio, BNN, CNBC, Fox Business, NPR, Barron ’s, The New York Times, The Wall Street Journal, USA Today, Time, Los Angeles Times, Bloomberg News, Pensions & Investments, and Advanced Trading.
Arnuk earned an MBA in finance from New York University’s Stern School of Business and a Bachelor’s degree in finance from SUNY Binghamton University.
Joseph Saluzzi is partner, cofounder, and co-head of equity trading of Themis Trading, LLC. Saluzzi has extensive experience in equities trading and is an expert in electronic trading and market structure. Prior to Themis, he headed the team responsible for equity sales and trading for hedge fund accounts at Instinet Corporation for more than 9 years.
Saluzzi has provided analysis to regulators, including the Securities and Exchange Commission and as a member of the Commodity Futures Trading Commission’s new Subcommittee on Automated and High Frequency Trading.
He has appeared or been quoted on market structure issues by media outlets such as CBS’s 60 Minutes, BBC Radio, Bloomberg Television and Radio, CNBC, Fox Business, BNN, The New York Times, The Wall Street Journal, USA Today, Reuters, Associated Press, Los Angeles Times, and Bloomberg News. Saluzzi also has authored articles for Traders Magazine, Dow Jones, Journal of Investment Compliance, and Journal of Indexes.
He earned an MBA in finance from the University of North Caro- lina at Chapel Hill and a Bachelor’s degree in finance from New York University.
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It's hard to see why anyone, after going through this book, would want to have anything to do with stock market investing. To be sure, the intention of the authors is not to scare investors away, but to motivate investors to demand reform. I'm not sure whether the specific reforms advanced in the book are either politically feasible or will actually cure the ills of hyper frequency trading. There are a number of other problems afflicting asset markets other than those limned by Arnuk and Saluzzi in "Broken Markets"; and their doesn't seem to be much interest in even comprehending, let alone tackling, these issues. Curiously, the authors of Broken Markets trace the rise of high frequency trading, not to deregulation, but to misregulation. But if this is true, how can we be sure that attempts to reregulate won't lead to an even greater disaster? We seem to be suffering from a failure of leadership in such matters. Hopefully, this book will help turns thing around and bring a bit more intelligence and wisdom to the whole issue of regulating and improving free and open markets.
One of the reasons to read this book, especially if you have witnessed the events and turmoil of the last few years, is to understand just how we have gotten to this point. Yes it focuses on HFT, but HFT is now probably more than 90% of the volume on any given day in the Equities markets. While not perfectly organized, since it covers quite a bit of ground, it still gives a good accounting of the history of the Equities Industry in the last 10-15 years. Yes it is an "insider's view" but that exactly what this subject needs. While not written as a narrative like Scott Patterson's "Dark Pools", it still manages to tell an interesting and compelling story with enough facts for the reader to understand what the flaws are and what can be done. Of all the numerous topics it tries to cover it is especially detailed when discussing the rise of HFT and Dark Pools. It's very hard to write something interesting about Exchange demutualization, Co-location, Reg NMS, Reg ATS, et al, but since the authors pull no punches, it makes for some very enjoyable reading.
The real reason to read this book is because the authors actually go out on a limb and offer solutions. Are all those solutions the right ones? Far from it, but I'd rather hear someone offer even the most ridiculous solution than offer nothing at all. It is thought provoking, informative and very entertaining. There are many people in our industry that have jumped on the anti-HFT bandwagon (and let me say for the record I don't think Sal and Joe are altogether anti-HFT) for nothing more than self serving reasons without offering real solutions; you don't get that feeling here. It is actually an enjoyable read with enough anecdotes to keep it from being tedious. It leaves the reader, especially anyone who has a very limited understanding of the equities markets armed with enough information to investigate further, and that is exactly what the authors want you to do.
This book passionately argues that our markets are broken as a result of HFT algorithms and the unfair conditions in which they operate. My summary of the argument as I understood it is as follows: In the "old days", the stock market was kept going by (human) market makers and specialists, who provided liquidity (i.e. being willing to buy or sell something when no one else was) and smoothing out fluctuations (e.g. by matching up large buy and sell orders). They profited from substantial spreads (e.g. bid and offer prices might be required to differ by intervals of 1/8 of a dollar), in addition to the privileged information they had. Then new regulations were introduced which allowed stocks to trade in intervals of a penny and which enabled fast electronic trading. While these nominally helped small investors by reducing spreads and taking out the middleman, they counterintuitively made things worse by causing market makers and specialists to be replaced by HFT algorithms. The HFT algorithms skim roughly as much money from the markets as the market makers and specialists used to, but without providing the same services. In particular, while the large number of high frequency trades nominally provides liquidity, when things get bad the HFT firms can simply shut down the computers and bail, as happened in the "flash crash" of May 6, 2010, when stock prices dropped a huge amount for no fundamental reason and then rebounded, all within minutes. In addition HFT makes it difficult for mutual funds that need to make large trades. Although a large trade can be broken into small chunks, HFT algorithms can sense that this is being done (with the help of information which they really shouldn't have access to) and work to move prices against you.
In addition to all of the above, there are some serious conflicts of interest and lack of transparency. Many trades are executed in one of dozens of "dark pools" whose activity does not appear in ordinary listings. A brokerage can choose among these venues to execute your order in a way which minimizes their cost of execution but which does not necessarily give you the best price. Data about your every move can be sold to HFT firms which will use it against you. HFT firms buy "colocation" (i.e. the right to place their computers in the same building as the stock exchange computers). This means that the stock exchange, instead of working to make a level playing field for all participants, is selling advantageous conditions to those that can afford the fee (as well as the necessary high tech).
I would give the book five stars for being thought provoking and informative (even though I was not convinced by all of the arguments). I am deducting a star for suboptimal organization. The book repeats the things that the authors are upset about a lot, but does not give a very clear and organized explanation of the basic facts, with interruptions for biographical interludes, and more repetition. It reads as if a collection of related blog postings were edited into a book. This is made worse by the inclusion of three guest chapters by other authors; while the guest chapters are well written by themselves (although I found their arguments more extreme and less convincing than those of the main two authors), they further repeated many of the same points. There are also appendices with "white papers" by the authors, but I didn't read them because I didn't want to hear the same stuff again (although maybe it is more clearly explained there).
Some of the arguments didn't quite convince me. For example, the "dark pools" originated as places for large orders (e.g. by mutual funds) to trade quitely without moving prices a lot. Later they became dominated by HFT. The authors seem to feel that the lack of transparency in the dark pools is good when it helps the "good guys" (mutual funds managing your hard earned savings), and bad when it helps the "bad guys" (HFT firms which skim investor pennies and perform no social good). This seems inconsistent to me (although I don't have a better suggestion and I admittely know extremely little about this topic). The first two guest chapters argue that the "flash crash" was a huge catastrophe, but if you are a long term investor, then you probably didn't notice anything (unless you were unlucky enough to sell using a market order during those few minutes). The last guest chapter argues that the introduction of penny increments for stock prices caused the loss or lack of creation of 20 million American jobs. What? The argument is that the penny increments put market makers and specialists out of business, reducing the money available to financial firms to shepherd small IPO's into the marketplace, with a resulting lack of job creation. Well, maybe something is going on there, but I think there are some other significant factors for reduced IPO's and jobs, for example, so many IPO's introduced in the late 90's were such junk that no one wanted to invest in anything like that anymore, and our country is losing its lead in education and technology so that many of our jobs can be done by workers overseas who will do so for much less.
Anyway, at the end of the book there are a few suggestions for improving the situation. Meanwhile, happy reading, and don't use market orders.
As a result many new rules have been instituted changing the investment climate, and this treatise indicts many of them, especially what has become known as high frequency trading ("HFT"), a method that allows "front running," something that was always illegal. The authors, two well-known institutional traders, have been conducting a long-standing effort to do something about the practice for several years. Their contention, of course, is that HFT is destroying investor confidence and portfolios, in general, by allowing these practioners to scalp trades with advance order knowledge and steal (often literally) pennies which mount up to millions of dollars.
It should be noted that conflicts of interest have always been present on Wall Street: Was the broker who sold you that stock acting in your or his best interest? But generally, the markets worked, companies were able to raise money, the public could amass stocks for savings and retirement. At present, however, the authors contend that this is not the case, especially when the very institutions (the SEC, NYSE, NASDAQ and other regulators) are more interested in profits and speed and volume than in the orderly markets of the past.
Read it and weep.
"Broken Markets" left me feeling like I had just wandered into 'Black Friday' (the retail version), and that my investment is as safe as the racks at Wal-Mart. Yes, I have diversified, and no, I don't shift my portfolio everytime the market hiccups. I am at least ten years from retirement and I am taking the long-term view. And with IRAs and CDs at fractions of a percent interest, I don't have a lot of options.
And that is what is scary. The discussion in the book of the flash crash, the regulatory reactions to it, and the continued debate over the causes does not give me a warm fuzzy feeling. As I write this, Facebook's IPO is trading at about half of its initial price (which was probably too high to begin with), and a mini-flash occurred two weeks ago [Knight Capital]. These events underscore authors Arnuk and Saluzzi assessments - even if they are not spot-on the causes. I'm not sure anyone is 100% sure.
Truth be told, most of the book was beyond my limited scope of financial acuity - but thorough re-reading got me the key points. HFT may not be the only culprit, but it is clear that the liquidity they offer is ephemeral, and at any rate is a side-effect to their function. Someone compared the Market to a casino, except that instead of the house making the rules, the high-rollers decide the winning hands. The trust that the average American once had in their financial institutions (including the market) is fast disintegrating. "Broken Markets" gives a clue as to why.
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