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Saturday, May 17, 2014

Flash Boys

Front running ("Front Running") is the practice of stockbrokers buying and/or selling securities when they take advantage of advance knowledge from customers' pending orders. Front running brokers either buy a stock before filling their customers' orders, which will drive up the price of the stock, or they sell a stock before they execute their customer sell orders, which will drive down the price of the stock.

For example, suppose a broker receives an order from a customer to buy 100,000 shares of Microsoft, but before placing the order, the broker buys 20,000 shares of Microsoft for herself at $100 per share, which has the effect of driving the price up to $102. Then the broker immediately sells her shares (to her customer) at the new price, generating a profit of $40,000 for herself and causing her customer to pay more for the stock if she hadn't front runned.

This practice is generally illegal, but in the world of high frequency trading (HFT), it is not. By acquiring high-speed access to many of the world's stock exchanges, high frequency traders learn (well, their computers learn) before others when major purchases and sales of stocks are about to occur, which allows them to front run and make a quick profit. All of this occurs in a flash, literally quicker than it takes someone to blink their eyes, and the profits on each transaction are small, but when high frequency traders do this thousands, perhaps millions, of times a day. The profits can be enormous, at least for the traders, and it's the rest of us, including our pension plans, who pay the costs by making less than we otherwise would have.

All this is the subject of Michael Lewis's new book, "Flash Boys: A Wall Street Revolt." It not only explores the intricacies of HFT, but it also tells the story of a handful Wall Street brokers who band together to reform the financial markets. They do this by creating an exchange in which HFT has no advantage whatsoever. It's a great read (well, I've been listening to it).

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