The authors point out some troubling aspects of the U.S. stock market resulting from its radical transformation over the past 15 years, culminating in the Flash Crash and the unintended consequences of reforms meant to increase market competition. They propose a few very specific rule changes as remedies.
During an astonishing 10-minute span on 6 May 2010, the Dow Jones Industrial Average plunged 1,000 points and then turned around and recouped its loss. In the time required to cook a hamburger (medium), some $700 billion in equity market value evaporated and rematerialized. Accenture’s market value, which began the session at more than $30 billion, briefly approached zero as its stock plummeted to $0.01 a share. Concurrently, Sotheby’s stock soared from $34 to $100,000 a share, temporarily giving it a market capitalization of $6 trillion, roughly equivalent to the gross domestic product of China.
Contrary to initial rumors, this hair-raising episode did not result from a “fat finger” error—that is, a trader mistakenly entering an oversized sell order. Rather, say Sal Arnuk and Joseph Saluzzi in Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street Are Destroying Investor Confidence and Your Portfolio , “the Flash Crash happened because it was designed to happen.” As Mary Schapiro, the chair of the U.S. Securities and Exchange Commission, told Congress five days after the event, some professional liquidity providers abandoned the market as stocks fell. Unlike the stock exchange specialists of old, a major class of liquidity providers in today’s marketplace, known as high-frequency traders (HFTs), has no obligation to stabilize prices in response to shocks.
Arnuk and Saluzzi, owners of the institutional brokerage firm Themis Trading LLC, have been publicizing problems involving HFTs, dark pools, and other features of the contemporary stock market since well before the Flash Crash. They contend that billions of dollars are being siphoned from retail and institutional investors by traders who use a fraction-of-a-second informational advantage to step in front of orders. This advantage, as Broken Markets demonstrates, does not arise solely from praiseworthy technological innovation. Rather, the stock exchanges generate revenue by permitting HFTs to locate their computers in the buildings that house the computers that match orders. A one-millisecond edge inherent in the physics of such an arrangement, say the authors, has an estimated value of up to $100 million a year to a large hedge fund’s bottom line.
Arnuk and Saluzzi, veterans of the pioneering electronic brokerage firm Instinet, do not suggest that it is unfair to develop and exploit new technology. They even acknowledge that high-frequency trading has improved liquidity in the deepest, most actively traded stocks. They maintain, however, that bid–ask spreads have widened on the other 95% of issues. This state of affairs, they say, has resulted partly from unintended consequences of reforms meant to increase market competition. No draconian measures are needed to correct the problems, according to Arnuk and Saluzzi, who propose a few very specific rule changes as remedies. 1
The authors also give pointers on how to avoid contributing to the high-tech scalpers’ coffers. This advice makes Broken Markets worthwhile reading for all equity investors. Those who undertake the task will benefit by starting with Chapter 10. It contains the book’s best-organized overview of the radical transformation of the U.S. stock market over the past 15 years, highlighted by the emergence of for-profit electronic crossing networks (ECNs) and culminating in the Flash Crash.
This essential background constitutes one of two guest chapters by market commentator R.T. Leuchtkafer. A third, by David Weild and Edward Kim of Capital Markets Advisory Partners, shows that since the end of the dot-com bubble in 2000, the United States has had an average of just 129 IPOs a year. In the five years preceding the dot-com bubble, the average exceeded 500.
Weild and Kim blame the drop-off on Regulation ATS (alternative trading system), which reduced the profitability of market making in shares of small companies. They assert, somewhat unconvincingly, that the reduced volume of IPOs is “directly responsible for a major part of the unemployment problem in the United States.” (This politically astute argument follows a well-trodden path of portraying opposition to regulatory actions as a plea for job creation.)
Arnuk and Saluzzi’s direct contribution to the book consists of 165 pages that draw extensively on 50 pages of Themis Trading white papers that are also included in the volume. A fair amount of duplication results, but also a bit of contradiction:
Since 1997, when the Island ECN introduced rebate trading, the equity market has used a maker/taker model. (p. 104)
Since the early 1990s, when the Island ECN introduced rebate trading, the equity market has used a maker/taker model. (p. 259; italics added)
Co-authorship maneuvers Arnuk and Saluzzi into an awkward mixture of third-person and first-person self-reference. The authors also reveal a penchant for redundancy (e.g., “reverts back” and “help facilitate”). Copyeditors should have corrected the use of “honed” in lieu of “homed.” The same goes for “Detroit” preceding “Denver” in an alphabetized list of regional stock exchanges.
These minor flaws should not distract readers from the important questions that Broken Markets raises. Even if it is unclear that high-frequency trading is “destroying investor confidence,” the authors point out some troubling aspects of the contemporary marketplace. Notably, the exchanges are selling investors’ transaction data to firms that use the data to trade against those investors. Arnuk and Saluzzi rightly observe that this is quite different from websites that sell data on consumers’ purchases to companies that hope to sell things to those consumers. The authors have already helped bring about limited reform by casting light on questionable practices. Wider dissemination of their message could build upon that progress.
—M.S.F.