Skip to main content

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

By Lex van Dam, Hedge fund manager, Special to CNN
updated 3:47 AM EDT, Mon April 7, 2014
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'

Part of complete coverage on
updated 9:54 PM EST, Tue December 23, 2014
A decade on from devastating 2004 Indian Ocean tsunami, the Red Cross' Matthias Schmale says that the lessons learned have made us safer.
updated 7:24 PM EST, Tue December 23, 2014
As soon as word broke that "The Interview" will hit some theaters, celebrations erupted across social media -- including from the stars of the film.
updated 1:44 PM EST, Tue December 23, 2014
Did a rogue hacker -- or the U.S. government -- cut the cord for the regime's Internet?
updated 8:06 PM EST, Tue December 23, 2014
Monaco's newborn royals, Princess Gabriella and Crown Prince Jacques Honore Rainier, posed for their first official photos with their parents.
updated 12:06 PM EST, Tue December 23, 2014
Tim Berners-Lee, the man credited with inventing the world wide web, gives a speech on April 18, 2012 in Lyon, central France, during the World Wide Web 2012 international conference on April 18, 2012 in Lyon.
What's next for the Internet? Acclaimed scientist Sir Tim Berners-Lee shares his insights.
updated 3:22 AM EST, Tue December 23, 2014
The United States and North Korea have long been locked in a bitter cycle of escalating and deescalating tensions. But the current cyber conflict may be especially hard to predict.
updated 4:00 PM EST, Mon December 22, 2014
A chilling video shows Boko Haram executing dozens of non-Muslims.
updated 6:34 AM EST, Mon December 22, 2014
New planes, new flight tests ... but will we get cheaper airfares?
updated 12:46 PM EST, Sun December 21, 2014
The killing of two cops could not have happened at a worse time for a city embroiled in a public battle over police-community relations, Errol Louis says.
updated 9:51 PM EST, Sun December 21, 2014
The gateway to Japan's capital, Tokyo Station, is celebrating its centennial this month -- and it has never looked better.
updated 11:21 AM EST, Sat December 20, 2014
Unicef has warned that more than 1.7 million children in conflict-torn areas of eastern Ukraine face an "extremely serious" situation.
updated 12:01 PM EST, Mon December 22, 2014
Each day, CNN brings you an image capturing a moment to remember, defining the present in our changing world.
Browse through images from CNN teams around the world that you don't always see on news reports.