Lecture Notes: The Stock Market and High Frequency Trading

Introduction

• Discussion led by prominent journalists: Steve Croft, Leslie Stahl, Morley Safer, Bob Simon, Scott Pelley.
• Focus on the fifth anniversary of the current bull market on Wall Street.

Current State of the Stock Market

• Longest and strongest bull market in history.
• U.S. stock ownership at record low, less than half of Americans trust banks/financial services.

Investigations and Public Concerns

• New York Attorney General & CFTC launched investigations into high-frequency computerized stock trading.
• Michael Lewis's book "Flash Boys" discusses the rigged nature of the stock market.
• Key players benefiting: stock exchanges, big Wall Street banks, high-frequency traders.
• Victims: Everyone invested in the stock market.

The Nature of Modern Trading

• Traditional stock market is mostly a photo op; real trading occurs in black boxes at exchanges.
• Trading conducted by robots at speeds faster than human capability (milliseconds).
• Complexity of the system obscures the reality of what's occurring, making it difficult to question.

High-Frequency Trading (HFT)

• High-frequency traders have a speed advantage, allowing them to front-run orders for profit.
• Example of front-running: Identifying a desire to buy shares and purchasing them before the original buyer.
• This results in increased prices, costing investors more.

Brad Katsuyama's Discovery

• Katsuyama, a trader at the Royal Bank of Canada, noticed irregularities in stock trading and suspected something was wrong.
• Problem: Orders were only partially filled; prices would increase before he could complete trades.
• Collaboration with a team, including telecom expert Ronan Ryan, led to discovering that high-frequency traders were exploiting the system.

The Mechanics of HFT

• High-frequency traders invest heavily in technology to gain milliseconds of advantage.
• Example: Spread Networks spent $300 million to build fast fiber optic connections, leasing access to high-frequency traders.
• High-frequency traders can react to slower trades and profit from them, leading to significant losses for investors.

Legal and Ethical Implications

• The legality of front-running in this context is troubling; it is seen as "legalized front-running" which is ethically questionable.
• The financial losses for investors can be substantial.

Solutions and New Developments

• Ronan Ryan proposes a solution: Send orders at staggered times to equalize arrival at exchanges.
• Katsuyama and his team create new software to implement this strategy, achieving higher order fill rates.
• Their solution leads to the launch of a new stock exchange called IEX, focused on transparency and fairness.

IEX and Its Impact

• IEX aims to eliminate the advantage of high-frequency traders and restore trust in the market.
• The exchange incorporates "speed bumps" to slow down trades for fairness.
• Strong endorsements from major financial institutions, suggesting potential for success despite facing challenges from established firms.

Conclusion

• Trust and transparency are positioned as key differentiators in the financial services industry.
• The story emphasizes the importance of restoring trust to the financial markets as a whole.