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Opinion: Exchanges are like casinos where certain players can see your cards

By Lex van Dam, Hedge fund manager, Special to CNN
April 7, 2014 -- Updated 0747 GMT (1547 HKT)
Traders work the floor of the New York Stock Exchange. (File photo)
Traders work the floor of the New York Stock Exchange. (File photo)
  • Hedge fund manager Lex van Dam says computers have taken control of exchanges
  • High frequency trading removes liquidity when it is needed, he writes
  • He says too many of the price moves are no longer determined by fundamentals

Editor's note: Lex van Dam is the co-founder of Hampstead Capital LLP, a London based hedge fund, and a leading financial educator in the UK. The opinions expressed in this commentary are solely his.

(CNN) -- When a fake Twitter message from the Associated Press issued reports of two explosions at the White House last April, the Dow lost 140 points and S&P futures dropped 20 points.

Over $10 billion traded before recovering within a few minutes, when it became clear that the report was not genuine.

It later turned out that the AP Twitter account had been hacked. The previous day Google had experienced a flash crash, dropping $20 in split of a second, before making it back within the next second.

This is now almost a daily occurrence. Most of these events don't even make the newspapers -- only specialist sites record them.

Lex van Dam
Lex van Dam

Our global exchanges have changed into Bitcoin platforms. The main culprits: the so-called high frequency trading firms with their superior system technology.

Computers with the ability to react to news faster than humans are a sign of the times. They are hard to fight.

It is not a riskless strategy so I can accept it is here to stay.

However, there are certain types of strategy that only computers can execute that I am extremely worried about.

One of these is based on detecting real, genuine orders in the market -- be they from pension funds, insurance companies, mutual funds, hedge funds or retail investors.

A typical institutional order would be to buy a stock at the average price for the day. Very soon after this order is put into the market it will be detected by the machines.

Normally even the broker who puts the order in can be identified. The HFT computers will then spend the whole day buying ahead of this order, selling out during the day at an artificially inflated price, with the HFT pocketing the difference.

The same holds true for small orders. The HFT shows some minimal size on the bid or offer and if they catch a genuine order they 'go with the flow' and trade ahead of it, once again forcing the real buyer to pay more than they otherwise would have done.

I notice this myself every time I trade on the exchange -- as soon as I place an order, the price suddenly runs away from me.

Many different HFTs are doing this over thousands of stocks every single day, thereby creating a giant multi-billion dollar front running industry.

The bottom line is that computers have taken control of our exchanges.

This billion dollar industry is very well equipped and often uses physical locations next to the exchange with dedicated pipes. This allows them to receive and send stock quotes before the general market.

They sometimes send so many quotes that the exchange feed slows down because of their 'quote stuffing'. There is plenty of evidence that the price we see on our screens is not the same price that is seen by the high frequency trading firms.

We are now trading in the dark, a tragedy in an era where we are all supposed to have the same access.

To me it is clear that too many of the price moves we experience are no longer determined by fundamentals or technicals, or by phenomena such as fear and greed, or even irrational exuberance; they are based on the unpredictable consequences of computers acting with no controls.

The main reason that this has not been stopped so far is because deregulation has allowed many new, privately owned exchanges to open, which are all fighting for business.

HFTs are the biggest players in town, often with over 50% of the volume. No exchange can afford to upset them. In fact, many exchanges pay rebates to attract them.

The HFT lobby will tell you that academic research shows that they provide liquidity and dampen volatility. I believe the opposite -- they remove liquidity when it is needed and increase volatility when it suits them. They represent a tax on all of us.

I was brought up to believe that the stock exchange allocates capital from investors to companies, and is the place to buy and sell stocks based on fundamentals. If we continue to treat our exchanges as casinos, where certain players can see the cards held by others, then we should not be surprised that we are gambling away the future of our market-based economy.

Read more: Holder: U.S. probing high frequency trading
Make high-speed trading illegal: Schwab
Wall Street responds to Michael Lewis' 'Flash Boys'

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