If You Buy Stocks Online, You Are Involved in HFTs

High-frequency trading has gotten a lot of buzz following the publication of Michael Lewis’ book “Flash Boys: A Wall Street Revolt”.  Although an astounding tale of how trades get hijacked by high frequency traders, the most compelling information it reveals is how most trades actually get executed. When investors put in an order to buy or sell a stock, they are unaware that often HFTs are involved; actually half to two-thirds of trades executed in the U.S. involve HFT, according to many experts. 

The proliferation of HFT began when the US government implemented new laws aimed at leveling the playing field by giving every trade the same chance of receiving best price execution.  Regulation NMS (National Best Bid and Offer), enacted August 2005, established “order protection rules” designed to prevent the execution of trades at inferior prices by requiring trades get routed to the best prices first then follow an ordered sequence of best prices until the full order is filled.

Reg NMS created a proliferation of exchanges in which orders can be filled; it also opened the door for more nefarious activities like front-running and kickbacks.This occurred in many forms but one in particular, the sale of order flow by online brokers, greatly impacts the individual investor. 

Online brokers sold order flow (the ability to execute orders) to the highest bidders, usually to high-frequency trading firms.  These trading firms took that information to front-run the trades so that the individual trades got executed at a higher price.  Similarly, the banks that regulated the orders also controlled the information about the orders.  As such, they were able to process the orders best befitting their profitability.  Usually that meant first sending it into their “dark pools”, their internal pool of stocks where they match buyers and sellers.  The orders, if not completely filled within the dark pools, were routed to other exchanges and it is surmised that the tread routes the banks chose depended on which exchanges paid the banks to most to receive the orders.  Banks and firms were paid to send orders to some exchanges creating an enormous conflict of interest.  In both cases the individual investor would be none the wiser, unaware of if he was receiving best pricing since online brokerage accounts are at an information disadvantage (online quotes are usually slow to update). 

The Bottom Line

A simple market order may not be so simple after all; individual investors should consider setting a limit on the price to "front run" the front-runners! Otherwise, the next time you hit the “Order Enter” button, you’ve gotta think “Am I getting the best price available?”