This is where high frequency traders come in. High frequency trader firms pay the primary BATS Global Market exchange ten million dollars to place algorithms on the file servers located at the BATS exchange. These algorithms see immediately the request for five thousand shares. Maybe one thousand shares or fifteen hundred shares get forwarded to the second exchanges before the algorithm recognized the large block trade, but once the algorithm recognizes the large block trade, it kicks into action. The HFT uses fiber optic lines to shave off milliseconds in delivery to the second exchange while most trades travel through the older slower phone lines. The HFT then quickly purchases the remaining shares to complete the original order placed at the market price faster through their fiber optic network. This technique is known in the industry as front running. Front running is executing an order just ahead of the original order and running the price up just a bit and pocketing the difference. “It has been likened to electronic robbery and called a tax on the individual investor.”
What happens next is what started the current investigation by the Department of Justice into high frequency trading firms. Now the HFT has inside knowledge and uses its algorithms to complete the trade by purchasing the remaining shares outstanding. The HFT then sells those shares that it recently acquired in a millisecond trade from the secondary exchange to the purchaser for cents more per trade. This may not sound like a lot of money, but according to the 60 minutes interview, it could costs a hedge fund that has net assets of Nine billion dollars close to 300 million dollars a year. Take the Apple stock purchase example and multiply it by the volume of transactions of the New York Stock Exchange and one could extrapolate that billions of dollars are being lost every year.
“Everyone who owns equities is victimized by the practices, in which the fastest traders figure out which stocks investors plan to buy, purchase them first and then sell them back at a higher price, said Lewis. To show how lucrative the tactics are, Lewis said a technology firm spent $300 million to build a line that would shave three milliseconds off the time it takes to communicate between New Jersey and Chicago, then leased it out to securities companies for $10 million each.”
As a result of front running Mr. Katsyama decided to leave his job and created his own exchange called IEX which stands for the Individuals Exchange. This exchanges objective is to create a market where high-speed traders have no advantage over the slower speed traders. The exchange is relatively small compared to other exchanges volumes but it is growing every day. Mr. Katsyama tells his customers that his IEX exchange is trustworthy and transparent. Mr. Katsyama is quoted as saying, “trust is a differentiation in a service business . . . that is a crazy thought.” Shouldn’t the public or those that...