Is the Stock Market Rigged?

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1 Is the Stock Market Rigged? J. Cannon Carr, Jr. Chief Investment Officer Charles E. Bettinger Director of Trading April 2014 With his recent book Flash Boys, Michael Lewis launched a firestorm debate about whether the stock market is rigged against the average investor in favor of high-speed trading firms. You may have seen the debate last week on 60 Minutes or CNBC, or read about it in the Wall Street Journal or Vanity Fair. It s a vital question, and it has struck a nerve. Despite the recent buzz, the debate over high speed trading has been around for years. Trading has always lacked transparency, but technology originally designed to help streamline trading has only made it more complex. It is often impossible to know who is buying or selling what, with whom. With that as backdrop, in this commentary we will discuss the high-speed trading landscape and whether we think it is having an adverse impact on investors. To summarize: Technology of high speed trading (computer algorithms, dark pools, fiber optics) has overwhelmingly helped investors by lowering trading costs. But with this benefit comes greater complexity and fragmentation, which opens the door to predatory traders. There are incentives that could lead to abuse. We are less concerned that a predatory trader could affect our own investments. Our holding periods are long and our trades infrequent. We have tools to improve our trade effectiveness. Even if there were an impact, the fractional penny per trade skimmed would be dwarfed by our long-term valuation approach and improved trading costs. Our real concern is that abuse (or even fear of abuse) could undermine public trust in markets and could present systemic risk due to lack of accountability and self-interest. The problem is that it is difficult to track high-speed trading. We welcome regulatory scrutiny; we hope it properly aligns incentives and creates transparency, not dense rules. Finally, despite the need for more transparency, we do not think the market is rigged against long term investors. The technology of short term predatory traders can do

2 nothing to change the fundamental drivers of stocks namely, cash flow generation or destruction. Investment discipline, as always, is the key to successful investing. High-Volume Trading at the Speed of Light The firestorm launched last week centers around a trading platform called high frequency trading (HFT). HFT involves using powerful computers running proprietary algorithms to conduct a large number of orders at extremely fast speeds. Ten years ago, high frequency traders moved in and out of positions within seconds. Now, with fiber optics and greater processing power, they execute trades in fractions of a second. Since high frequency traders hold securities for very short periods, each trade typically earns a fraction of a penny. Success therefore requires trading in extremely high volumes at literally the speed of light. Conducting several million trades a day with the fastest connections and the best algorithms creates the profit model. Good or Bad? Proponents of HFT say that these platforms enhance liquidity and lower trading costs 1. Many HFTs got their start as approved market makers (i.e., liquidity providers) to help other traders. Some have taken to more active trading strategies, capitalizing on speed and complexity. At its basic level, there is nothing wrong with that. As an example, consider when an HFT firm sells stock at the offered price and buys at the bid to capture the spread like traditional market makers. The volume has tightened the trading spreads and helped drive trading costs down on low volume trades (i.e., it s now a few pennies from the old days when $0.125 was the lowest price). That arguably HELPS the average investor, although the liquidity provided is not necessarily sticky, dependable, or neutrally provided. (We therefore prefer to say that HFT does not provide substantive liquidity; it provides self-interested volume an important clarification.) Critics say that HFT invites abuse when active trading goes one step further, such as when a HFT firm combines speed with knowledge of other people s trades. If this occurs, the playing field is not level and HFT firms can take advantage of other market participants in a predatory way. As an example, an HFT firm may see a large order pending and realize that it will take multiple iterations to fulfill. There are several ways for it to game the order, as we discuss below, scalping profits in the process. 1 While we agree that HFT firms have improved liquidity, we suspect this liquidity is less dependable when it counts think back to the flash crash of 2010, when HFT firms exited the market to protect profits. 2

3 The problem is that it is difficult to pinpoint potentially abusive practices by HFT firms. Trading on insider information or manipulating market prices is clearly against the law, but having the highest speed or best processing power is not. Loopholes exist in the legal framework governing securities trading, which creates gray areas and risk of predatory (but not technically illegal) behavior. Since the HFT community is not likely to police itself, we are glad to see increasing regulatory scrutiny to clarify loopholes and investigate potential abuse. Where There s Smoke, There s Fire HFT has a legitimate place, but we would not be surprised if some HFT firms used information to game investor trading activity. Signs of potential abuse: Colocation and Latency Arbitrage: With colocation, HFT firms put their trading servers right next to an exchange s servers, which shrinks fiber optic connections from several miles to less than a few feet, to get a nanosecond speed advantage. Being close to the exchange server, there s potential for them to evaluate slower-moving quotes (latency) from traders running slower algorithms from off-site locations. In turn, the HFT firm can quickly arbitrage any price differences away especially if this information is sold by exchanges as preferential data feeds. Speed plus special access arguably creates an uneven playing field. Order Stuffing : HFT firms are often paid to create liquidity. This means they buy or sell stocks to enable trading. It is indeed odd that a reportedly 95% of all bids are cancelled. Perhaps these firms are simply managing their own risk by cancelling orders that are no longer attractive a few nanoseconds later. Or, perhaps they are simply stuffing orders into the market to get their payment as market maker. Or, even worse, perhaps they are pumping up prices for their own arbitrage advantage. That would be market manipulation, in our view, which is illegal. Guaranteed Results: In its IPO filing with the SEC in March (which has now been delayed due to the firestorm), HFT firm Virtu claimed that we had only one losing trading day during a total of 1,238 trading days. Maybe Virtu s technology is truly that good. But we don t think the odds work that way in trading. It is too easy to have a trade go against you, just by sheer misfortune, in our view. But It s Not Rigged Even if these predatory practices occur, we do not believe the market is rigged against the average investor. As we said at the outset, the technologies used in high speed trading have actually enabled low-volume orders to be filled more efficiently. This reduces trading costs for the average investor. 3

4 A subset of HFT firms being able to skim and gain profits at the expense of large institutions or other traders is not the same as meaning the market itself is stacked against investors. Volatile prices actually create opportunities in both buying and selling. Capitalizing on this volatility requires patience and tenacity over long periods. In the short term, prices may be irrational, for any host of reasons. They can be driven by emotion, liquidity issues, or various trading strategies. But longer term, stocks rise as value is created and fall as value is destroyed. The process of corporate value creation (profits, returns, cash flows) cannot be manipulated by trading firms using short-term (daily or even minute-byminute) strategies. Final Thought As regulators review HFT, our hope is that their work will lead to greater transparency in HFT trading, rather than heavy legislation or rules. The goal should be to align incentives to support profit-making based on competitive advantage and not predatory practices. In particular, we expect regulators to review colocation practices, proprietary data feeds, and potential areas of market manipulation. At its heart, it should accommodate further innovation and yet foster confidence by the investor community. See our commentaries and newsletters at for more detailed discussion of our research and views about investing in today s markets. ADDITIONAL INFORMATION The CornerCap Approach to Trading Stocks Our goal when trading stocks is to fulfill the investment objectives of our portfolio managers with as little impact on the price of a stock as possible in the most cost effective way for the client. We have safeguards in place to help guide trading in unexpectedly volatile markets. For higher volume large cap trades our trading platform offers straight-forward processing for when our execution size is less than the bid or offer size for non-aggregated orders. The greatest benefit here is that the trader has hands-on control of the orders. In the event of high volatility in market prices, we can act quickly. When prices run up, we can pull sell orders back from original limits and get higher executions. The same principle holds for purchases during market declines. These capabilities, combined with the use of limit orders, protect our clients from price shocks or unexpected developments (such as HFT manipulation?) during trading. For trades in more illiquid small stocks, we can 1) use our custodian s trading desk for algorithmic and dark pool trading or 2) divert the orders to other proven trading platforms such 4

5 as Instinet to take advantage of the tools they provide for discrete executions. Algorithms are mathematical programs that allow us to place an order with very specific, customized parameters on how we want it to trade. These approaches help execute a large block of stock in a lightly traded security without dramatically impacting price. Notably, high frequency traders are less effective manipulating illiquid small stocks by definition, HFT firms need to trade big stocks with plenty of volume frequently throughout the day. For additional information please contact: Cannon Carr, Chief Investment Officer Patrice Smith, Administrative Manager (404) (Atlanta) Merriweather K. Raidle, Client Service and Portfolio Manager (704) (Charlotte) 5