Is Wall Street Rigged?

Is Wall Street Rigged?

The CBS news program 60 Minutes on March 30 and a March 31 article in the NYTimes discuss a new book about the US stock exchanges.  The opening statement in the 60-Minutes piece is, “Wall Street is rigged.”

Is it?

If the question is, “Is someone preventing the individual investor from making money,” the answer is no.

But if the question is, “Is someone taking unfair advantage of regulations that haven’t yet caught up with technology, to ensure they always make a profit,” the answer is yes.

So in the interest of grabbing headlines, 60-Minutes refers to this as “rigged.”

The practice in question is called “front-running.”  Very high speed computers and networks can gain an unfair advantage to guarantee a tiny profit per transaction.  Front-runners can “see” trades just before they execute and get in line in front of them; since they know the direction of the next trade, they can always make a profit.

For most investors, the potential impact of front-running is tiny.  But added up across the huge volume of stock transactions per day, the total amount is large.

The NYTimes article gives an example of front-runners making 0.1% on the sale of a large block of stock.  So a $1M stock trade would incur a $1000 “penalty” from the front-runners.

The total daily volume on the New York Stock Exchange can be over $50B, so a 0.1% profit for a front-runner would be $50M — in one day!

But most of us aren’t trading in numbers quite that big.

One way is to reduce your trading frequency.  Some studies have shown that frequent trading harms investment returns anyway because of transaction costs.  Actively managed mutual funds usually do a lot of trading. Index funds do not. So index funds are less susceptible to the front-runners.

Warren Buffett says his favorite holding period is: “Forever.”  He doesn’t trade very frequently.

Several regulators have become interested in this new type of front-running, and will probably try to impose regulations to end it. (Other types of front-running are already illegal.)  That’s a good outcome from the press coverage.

But in the meantime, it’s important to maintain some perspective on stories in the news.  Individual investors can still make money in the stock markets.

Disclosures:  This article is of a general educational nature, not specific investment advice for an individual.   Investing involves risk of loss.  No investment advisor can guarantee a gain or any specific investment performance.  Past performance is no guarantee of future results.