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Dissecting the 'frog'

What happens when we trade stocks? It's a complex answer, but here's a stab at it

Hey there, time traveller!
This article was published 16/5/2014 (1165 days ago), so information in it may no longer be current.

We all participate in the stock market one way or another. While we rely on it almost daily to create wealth, it's probably safe to say a lot of us don't really know that much about the stock market's mechanics.

Yet maybe you've had questions lately, especially in light of Michael Lewis's new book Flash Boys, an investigative look at the world of high-frequency trading (HFT).

What happens when we trade stocks? It's a complex answer, but here's a stab at it.


What happens when we trade stocks? It's a complex answer, but here's a stab at it.

Lewis contends the stock market is rigged in favour of high-frequency traders. These are trading firms that use computers to trade at light speed, accounting for 50 per cent or more of all trading in the U.S.

That the market is a slanted playing field isn't all that shocking to many. Most folks thought that before Lewis published his book. Yet the issues surrounding HFT also raise an important question few people ask: Just what the heck happens when we make a trade these days?

In an attempt at delineating its mysterious anatomy, the following is a stab at dissecting a trade like a poor, unfortunate frog in high school biology class: badly butchered, but illuminating nonetheless.

The first thing you should know about today's trading is the image of a bustling trade floor at a stock exchange where traders feverishly buy and sell securities no longer applies.

"What used to happen was you'd call your broker and say, 'I want to buy XYZ,' or the broker would call you and say, 'This is what you have got to buy today,' " says Alan Fustey, a money manager with Index Wealth Management, with 29 years of experience in the business.

If you agreed to a trade, your broker would get hold of someone on the trading floor. That person would go to a trading post where the security was sold.

"And he'd find another guy who was willing to sell, and they'd have a little conversation, write it down on a paper ticket, agree on a price, and then your broker would be called and he'd call you."

That process would take about 30 minutes.

Today, it's different story.

"Now, it's done electronically, and there is a whole bunch of different ways it can actually work," says Fustey, a licensed dealer and equities analyst.

In Canada, those ways are a lot more limited than in the U.S., but essentially, a retail investor -- the little guy -- who wants to buy 100 shares of the Royal Bank of Canada (RBC) could have that trade executed a few different ways.

Most likely it would flow through a marketplace run by the TMX Group, owner of the Toronto Stock Exchange on which RBC in listed.

The order goes through your brokerage's internal trading platform, and if it goes to the TMX, it is sent to one of its marketplaces such as the TSX or Alpha (we'll explain what that is later) for execution at the best available price, says Shane Quinn, spokesman for TMX Group in Toronto.

"TMX sends confirmation of the trade, with execution at the best price available across Canadian marketplaces, back to the dealers/banks that then send trade confirmation to the investor."

All of this happens electronically at very high speed so your trade can be completed in seconds -- or less -- instead of minutes.

Yet trades don't always go through the TSX like we think.

While they likely might, trade orders also might be executed via an alternative trading system, or ATS for short. The aforementioned Alpha, run by TMX Group, is one of them.

Only licensed exchanges such as the TSX and its sister TXV -- the venture exchange -- can bring companies into the public realm for listing so they can be traded widely, but once tradable on an exchange, a security can be traded on an ATS.

According to IIROC, ATS systems have been in place a number of years. Some market participants believe ATS systems are beneficial because it's assumed they increase marketplace competition.

ATS systems can be "lit," where data about trading is public knowledge, or "dark" -- those so-called dark pools -- where the orders are not publicly disseminated.

Most big brokerages in Canada are linked to all possible marketplaces, exchanges and ATS systems where a security is listed to ensure they can get the best price for an investor.

Getting the best price is a matter of law in Canada. Rules ensure if you buy 100 shares of RBC at the market price, you get the best possible market price, so if it's available at $60 a share on the TSX when you put in the order, you can't have your trade executed for $60.01 in another marketplace.

The catch with buying or selling stock at market price, however, is prices are changing continually during the trading day, so the price you thought was market price might not be a split second later.

That's where a lot of the controversy regarding high-frequency trading becomes an issue. Speed is king in HFT, with platforms built by physicists, mathematicians and computer programmers that use algorithms that find stock-price patterns by rapidly sifting through real-time trading volumes.

How the algorithms are used for trading is central to the controversy surrounding HFT, says Fustey, who wrote a 2011 article on HFT in Advisor Perspectives.

Big trading firms will use HFT to break up large trades into smaller ones into the market at the speed of light to obscure their strategy regarding a trade.

That's good, because it helps avoid pricing distortions that can arise from very large single trades.

"But then there's other high-frequency trading where firms are running computer programs designed to seek out these aforementioned kinds of trades so they can get in front of them and take advantage of it," he says.

"That's more of a predatory high-frequency trading, and that's what people are more concerned about."

It's also why HFT firms are building bigger, faster computers as close to exchanges as possible to get infinitesimally small, split-second advantages.

"For the average person trading a couple of hundred shares through a discount brokerage, the market's not rigged that way, because no one is going to try to get in front of your 100-share trade for RBC stock and try to make an extra penny, because there's not enough money in it," he says.

Still, that doesn't mean that we, the masses, aren't getting a raw deal as a result of HFT. Most people own mutual funds, or we're in pension funds, including the Canada Pension Plan.

Predatory trading could affect pricing for very large trades by these market players, Fustey says.

So perhaps Lewis is right: HFTs could be costing us billions of dollars over time -- just not the way we think, Fustey adds.

"The little guy is getting screwed, only indirectly."



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