Are You Being Flashed?

Well, maybe not you personally.

Michael Lewis, author of Moneyball, The Blind Side, Liar's Poker, and The Big Short has a way of stirring up controversy. That's fine. That sells books. His latest, Flash Boys, is no exception. Lewis made the rounds this spring, most notably on 60 Minutes, telling anyone who'd listen the stock market is rigged by sharks known as High Frequency Traders (HFT).

Not so fast says Ronan Ryan, Chief Strategy Officer at IEX and the subject of Flash Boys.

Ryan, whose firm is dedicated to re-leveling the playing field (the playing field in this case being a number of servers in a data center), stood before a room full of Chartered Financial Analysts at the Sheraton in Clayton, MO last week and explained how predatory trading worked, how he was stopping it, and how it affected trades.

In a nutshell, all trading on all US exchanges and private, brokerage-owned exchanges called dark pools, is done by computers in four data centers in New Jersey. When you (or a mutual fund) puts in a stock trade, your broker's terminal enters an order at one of these exchanges. HFTs let their computers enter the trades for them - it's all algorithms, no mouse clicks. The HFTs have co-located in the same buildings as the exchange's computers (paying the exchanges for the privilege) and thus have a speed advantage.

When a large order comes in, usually the market is not big enough to handle the whole trade at one exchange. Here's where the HFTs come in. They see the partial order hit the nearest exchange (Weehawken in the case of orders coming from NYC) and jump in front of the rest of the order, raising the price of buys or depressing the price of sell orders.

The good news is, for the individual investor their orders are usually small enough to execute all at once so they are not being hurt. The bad news is, if you're investing through mutual funds (or pension funds, or an insurance contract) you probably are. So, in a win for David (sort of), it's only the Goliaths being hurt - unless you're riding on Goliath's back.

IEX has put in place measures to slow down the information flow for these HFTs and is attracting business from the Goliaths. They are the 6th largest exchange/dark pool (out of about 35), but still only captures 1% of trades.