"The best analogy I think is that your family wants to go to a concert. You go onto StubHub, there's four tickets all next to each other for 20 bucks each. You put in an order to buy four tickets, 20 bucks each and it says, "You've bought two tickets at 20 bucks each." And you go back and those same two seats that are sitting there have now gone up to $25."[2]
The analogy is very alarming! What do you mean the price is one thing and then they can change it on you as soon as you go to buy the tickets!? The analogy is also sneakily close to being accurate, but it falls well short by leaving out a couple key pieces of information. In the analogy there is one exchange--StubHub--selling you all the tickets you need. Imagine if there were not only StubHub but also several (nearly) identical exchanges, called TicketCity, and PassStation. In order to make the analogy accurate, there would have to be different exchanges selling those four tickets. Enter TicketCity and PassStation. Furthermore, concert tickets are particular; shares of stock are not. Each share of stock is just as good as the next, unlike concert tickets. If this were the stock market, then one exchange would not be selling all four tickets; you would also be happy with any four tickets, not a particular set of four. For example, say that there is one ticket being sold on TicketCity, two tickets being sold on StubHub, and the final one ticket is being sold on PassStation. A more apt analogy:
Your family wants 4 generic passes to go to a music festival. You see StubHub has two for $20, TicketCity has one for $20, and PassStation has one for $20. You go onto StubHub and put in an order for two for $20 each and it says "you've bought two tickets at 20 bucks each." Now you go to look at PassStation and TicketCity, and they are now selling their tickets for $25.
In order to buy all four tickets, you could have two options. One potential option is to send an order for four tickets to StubHub in New York; they will then sell you the two they have listed at $20 and forward the subsequent requests to TicketCity and PassStation on your behalf electronically. The second is to manually send three unique orders yourself to StubHub, PassStation, and TicketCity by sending each an electronic signal one-by-one. In either case, you are not guaranteed to get all four at the same price. As soon as the signal is processed by the first exchange, say StubHub, they will update that it sold the tickets it had listed for $20. That public listing is viewable by the sellers who are on PassStation and TicketCity, too. Generally, that is a good thing; it helps prevent people from giving "special deals" to their buddies. Say that in the time it takes you or StubHub to send the next message, the sellers at that exchange see that someone bought 100% of the available tickets on StubHub for $20. In that case, they might very well guess that there may be more tickets desired. As a result, they can attempt to change the price for the one ticket they are selling on their exchange as a result of change in demand. If they can change their price to $25 before your order gets to their exchange and they were the only selller willing to sell the ticket for $20, then your order to buy a ticket from them at $20 will not be fulfilled[3]. You will instead have to try again to buy the ticket for $25. This is neither criminal nor evil. Furthermore, it does not sound rigged to me, it just sounds capitalistic.
Long story short: the market is not rigged. Well. It might be, I don't know, but it is not rigged by the HFT trader trying to "front run" your order in the way they described.
- Disclaimer: I have not yet read the Flash Boys: A Wall Street Revolt by Michael Lewis yet, so I cannot speak to the book's accuracy, validity, or worth. The notes here are merely comments on the segment 60 Minutes ran.
- "Is the U.S. stock market rigged?" http://www.cbsnews.com/news/is-the-us-stock-market-rigged/
- In reality the HFT firms can (and I would bet they do) go one step further. If they have a high degree of certainty there is a large order for many more tickets en route, then they could buy all the tickets listed at $20 on the exchange, and then list the bunch of them at a higher offer price. If they can do that before your buy order comes in, they can effectively buy low and sell high in no time flat and make a couple pennies per share in the process. This more involved example is still a response to new information indicative of an increase in demand, and still doesn't seem rigged to me.
Fantastic explanation. I agree that does not seem 'criminal' or 'rigged'. But I think there would be a valid complaint if the good you’re trying to purchase has an unlimited supply. Unfortunately for stocks (or tickets), supply is limited which Katsuyama doesn't factor in. Because there is only a fixed number of tickets (or stocks), when the supply of tickets for sale goes down, the price logically goes up.
ReplyDeleteUsing my own analogy to further criticize Katsuyama's analogy:
You're heading out to by a few cases of a very unique beer for a party. It's a beer that every store has, but it is well known that there are no substitute beers. You go to the store where the price is the lowest. (Remember: When you buy something for $10, it means you value the good to be more than $10, otherwise you'd keep the $10.) Upon reaching the checkout lane, an employee notices the multiple cases of said beer in your cart and says that only your first case will be the price you on the tag, any subsequent cases would be $5 more. Is it rigged? No. But it does seem a bit unethical. In theory, assuming the $5 more per case made the beer at another location cheaper, you would go buy the rest there instead. Basic economic textbook examples would describe market equilibrium causing the original store to reduce the $5 surcharge to the exact price where it is not financially worth going to the other store. However, most economic textbook will mention things such as the price in gas or lost wages to get to the other store. These examples forget to include the variable of time in regards to supply and risk. I could pay the surcharge or I could risk going to the cheaper store to get the lower price. However, the risk that exists that more beer is purchased in the interim, followed by subsequent increases in its price. That is why $20 tickets become $25 tickets. Therefore that's why it's a bad analogy.
Technical note: if you go to an exchange/super market and they are listing "3 cases of beer for $10" when you submit your order/check out for 3 cases of beer for $10, you should be filled. Period. No bait and switch allowed...
Deletebut if there isn't a X for $Y type of deal, and it's simply labeled a given price, it's effectively saying given the current supply, the value of a given share (or case of beer) is $Z. Trying to buy multiple shares means that the seller will have a smaller remaining supply and could very well ask for more. You can hope for the same price, but you're not guaranteed.
DeleteI think about when I collected baseball cards as a kid. If I two of a very valuable card, I'd try to trade one to my friend. If my friend would have wanted both of the cards, the price would have been higher than twice the price had of if he just tried to trade for the one.
Either way, I don't think that makes the system 'rigged'.
I think better and simpler explanations of the separate reasons why for why people consider it 'rigged':
ReplyDelete#1: This hasn’t changed with advances in technology, but people with more people invested in the stock market, more people don’t understand the how stocks are different from traditional goods.
Stocks are part-ownership of a company, therefore a conceptual good. You want to buy a physical good, like Cheerios, you pay the cost at the grocery store and then you either consume the Cheerios and there is no more value or you don’t. If you don’t consume the Cheerios, traditionally, the value won’t go up. Contrarily, conceptual goods don’t necessarily depreciate in value like physical goods. People own stock with the purpose of their value increasing over time. Further, if people thought the price of Cheerios was going to go up all of a sudden, you'd see that Cheerios would begin to sell like stocks. However, with resale laws, the quantity of sellers and considerable supply (among a host of other factors) inhibit the few people who try to resell the box of Cheerios for a higher price and make a profit. Resale laws and considerable supply don’t exist in terms of a company’s stock (which you can’t go elsewhere to buy at a different price either), so they will never start being sold like Cheerios.
#2: Technology has given trading firms the ability to understand the market faster and therefore have an increased ability to price dynamically to increase their profits. Places like movie theaters having been pricing movie tickets dynamically (based on age or being a student) for years. Obviously trading firms don’t price based on age because stocks aren’t bought the same way movie tickets are.
#3: People don’t understand in this day in age, if you expect the value of something (like a company's stock) to rise, you don't get to buy it at the price it's at when you determine you want to buy it. You have to buy it at the price it's at the exact time of transaction.
HFTs are basically keeping eyes on people's shopping carts (and available supply) and then beating them to the front of the checkout line, raising the total cost to the non-HFTs. This makes it very difficult for day traders and the common person to make short term profits because the value of the stock at their time of purchase is effectively the stock’s true value because the HFTs have beaten the day traders to the profit. Unless technology is completely eliminated, the fastest firm will always have an advantage.
It's not rigged; it is just harder to compete for slower firms seeking profits in the short term.