There’s been quite a buzz in the media and in Washington since Michael Lewis appeared on “60 Minutes” a number of weeks ago asserting that the stock market is rigged.  The topic was high frequency trading (HFT), and for those that missed the broadcast (or the subsequent media frenzy), it’s a combination of high speed network connections and computers that allow certain traders to see and execute buy or sell stock orders before other market participants.  According to Lewis, this drives up the price of purchasing or selling securities for everyone else.  The analogy used by Brad Katsuyama, a trader at Royal Bank of Canada who was also interviewed during the segment, was one involving purchasing four tickets online for a concert at $20 each and ending up being stuck paying for two tickets at $20 and two at $25.  Is HFT really the evil predator described by Lewis?

It helps to understand what trading firms do.  Basically, they provide liquidity.  They act as the middleman between buyers and sellers, making a little off the top from each trade.  When there are lots of market participants for a stock, there is lots of liquidity, and that tends to keep trading costs (known as bid/ask spreads) low.  If HFT firms are able to get in on a trade before other firms, and are willing to make the trade for a lower cost, they would be benefiting investors.  It’s the other trading firms that would be negatively impacted (i.e. Royal Bank of Canada).  On the other hand, if HFT firms are colluding to sell the securities back and forth to each other (in much the same way that Enron did with electricity) in order to drive up the price before a trade is executed, or trying to corner the market in some other way, that would not only be harmful but blatantly illegal.  But it’s hard to imagine them getting away with that in today’s regulatory environment.  Whatever the actual situation, it’s extremely difficult to determine the net effect HFT firms are having on markets.

Should HFT be allowed to continue?  I believe the playing field should be level for all participants, and regulators need to do all they can to reassure investors that the capital markets are fair.  But if regulators were to take some action that resulted in overall reduced liquidity, the consequences could be worse than if they had not acted at all.

In any case there are things stock market investors can and should be doing right now to avoid the problem.  One is to use limit orders rather than market orders when purchasing or selling individual stocks or Exchange Traded Funds (ETFs).  A buy limit order, for example, is only executed if the actual price is at or below the specified price.  Even if an HFT firm were able to see the trade first, it would be unable to execute it except at the stated price.  Another trick is to require all shares of a trade to be executed at the same price.  Many brokers offer this capability even to individual investors.  That would pretty much eliminate Katsuyama’s concert ticket problem.

Whether or not HFT is a problem is unclear.  The bigger problem, though, is the media.  They – and Michael Lewis, who was on the show to promote his book – are in the business of selling drama, not knowledge.  Which would get your attention more: the assertion that the stock market is rigged or the assertion that there are a few traders that are making lots of money by getting their trades in early?  If Katsuyama’s concert ticket purchase analogy had more realistically been described as getting two tickets for $20 and two for $20.10, would anyone have cared?  (Note also that Katsuyama benefits from all the hype since he was promoting his new trading company).  The media always exaggerates the reality of any situation in order to heighten the emotional content and is frankly your worst enemy when it comes to seeking useful investment knowledge.  This interview was no exception.

My greatest concern is that ordinary investors – particularly those that are already distrustful of the stock market – will avoid putting their money into stocks after seeing the broadcast or reading Lewis’ new book.  That could have a devastating effect on their ability to support their retirement goals.  If they eliminate stocks from their investment portfolio, with what will they replace them in order to achieve a similar return over the next 20 or 30 years?  Sweeping statements like “the stock market is rigged” can cause more harm to more people than the trading irregularities being highlighted.  My advice: just pay no attention.