Andy and Emily
Since my beard has long been completely white there’s not much I can do to disguise my age. That being the case, there’s probably little further embarrassment in letting you know that I watched both Andy Rooney and Gilda Radner’s character “Emily Litella” on live television. What did these two have in common? They both wrote their own commentaries and both expressed outrage on topics of the day. Emily was always confused about the details and normally ended her speech with the words “Never mind”. Andy’s early commentaries were satires about everyday peeves but over time they seemed to more represent his true feelings about some sensitive subjects and his act began to wear thin. He made his last appearance on CBS’s 60 Minutes in October of 2011, dying in November of that year.
I no longer watch 60 Minutes regularly but this morning I find myself wishing that Andy were still around to close the show. This past Sunday’s edition included an interview with author Michael Lewis. He was promoting his new book, Flash Boys, about Wall Street’s “high speed traders”. As we all know, today’s 24/7 news cycle makes it difficult to stand out from the crowd and get your voice heard. How was Mr. Lewis able to rise above the background noise? He advised 60 Minutes that the stock market is “rigged” by a cabal of high frequency traders, aided and abetted by the stock exchanges on which they trade. His book describes a practice known as “front running” which has long been illegal.
Those who watched the film The Wolf of Wall Street saw front running in action. Jordan Belfort’s scams took place at a time when trades were taken over the phone by brokers who turned them over to clerks to transmit to the trading floor where human beings worked face-to-face to execute them. Stocks transactions were priced in eighths, meaning prices moved 12 ½ cents at a time, and commissions were fixed at rates much higher than they are today. Trade confirmations were mailed to customers and payment was due in five business days. In the movie, brokers from Belfort’s firm, Stratton Oakmont, took orders for shares the firm either already owned or planned to purchase. They sold those shares to their customers who really had no way of knowing what a “fair” price for the stock might be. They got both a commission and a profit on the transaction: front running.
Today, stocks are priced in increments of a penny or less and orders are often placed electronically by investors themselves. Commissions are much lower, confirmations are nearly instantaneous and most trades settle the next day. This streamlined approach seems much better because of the lower costs and apparent transparency. In today’s high tech world, how could front running still be possible?
Have you ever seen a stock ticker crawling across a TV screen below the talking heads? Those prices are delayed by 15 minutes. That’s much more current than what was available in the old days but still is not real time. The exchanges consider those delayed prices to be in the public domain, meaning they are free for anyone’s use. Those who want second-by-second pricing have to pay the exchange for it. Once started down the pay-for- timeliness path, what’s to prevent an exchange from offering an even better product, i.e. even quicker quotes for even higher fees? The answer is “nothing”. And, in fact, that’s what high speed trading is. Exchanges charge brokerage firms extra fees for quicker quote access and even allow them to co-locate their servers with those of the exchange. There’s effectively no latency for those who are willing to pay for the privilege. This can shave several hundredths of a second off trading time and that’s what Mr Lewis has written his book about – the ability of some firms to operate a tiny bit ahead of the rest of the market and make a tiny bit of extra profit on each transaction.
Much of what Mr. Lewis says is true but it’s hard for me to see those traders as the villains. If you must name a bad actor, how about the exchanges? They’re the ones who offer the service and make money on every high speed trade, good or bad, through their subscription fees. In fact, high speed trading doesn’t always work. Do you remember the Morgan Stanley trader who used such information to lose $9 billion between 2004 and 2006, or more recently, 2012’s loss of $2 billion by J P Morgan’s “London Whale”? Access to a high speed trading network is not, in and of itself, a guarantee of market success.
Last year these traders asked the exchanges to add an extra decimal place to pricing. In my early days as a broker, stocks were priced in eighths of a dollar but Mr. Lewis’ villains have made it possible to trade in thousandths of a cent. If the high speed trader makes a fraction of a cent on a transaction, could it be that investors are still better off than when prices moved twelve and a half cents at a time? In fact, it’s quite possible for any investor to profit from this injustice simply by buying shares in one of the exchanges. All the significant ones are now publically held.
A larger question, though, is why would a true investor care? I agree with Warren Buffet who once said that his favorite holding period is “forever”. If you are an investor with a long time horizon, what real difference would it make if a high speed trader made an extra couple of thousandth of a cent on your purchase? Between now and “forever” it’s simply not going to matter. Perhaps more to the point, most of these wicked traders are money managers who are trading on behalf of their investors – perhaps on behalf of your own 401(k) plan.
Andy Rooney always had a nice line in crankiness and here’s where we need his help again. Oh for the old days when he might have closed the program with a rant about authors plugging their books on national TV or the next Saturday Emily could review the situation, realize that nothing really terrible is going on and close her commentary with “Never mind”.