Why Small Investors Can't Win

09/03/2009 12:00 pm EST

Focus: MARKETS

Michael Brush

Columnist, MSN Money

Michael Brush, contributing editor of MSN Money, says new trading technologies have tilted the playing field towards giant institutions that have massive computing power.

PCs, broadband Internet connections, online brokerage accounts brought democracy to Wall Street, leveling the playing field between everyday investors and the insiders, right?

Wrong.

In fact, computers are ruining investing for the average investor.

Sure, your PC lets you see when your stock is moving. But multiply its computing power by thousands, add a throng of software geniuses earning more than $1 million a year, and the biggest brokerages and hedge funds can stay a few steps ahead of any move you can make.

Over half of all trades are done by Wall Street insiders using quick-fire trading systems; 7% of all trading is done inside secretive dark pools. "The public is getting screwed here," says one hedge fund manager who follows these developments closely.

Here [are] three of the tech tricks that make life tougher than ever for the average investor.

1. High-frequency trading.
In high-frequency trading, or HFT, computers use sophisticated algorithms to spot a fleeting price or complex combination of trades, then lock in gains at a clip that only a high-speed computer could pull off.

HFT computers can detect large buy orders for a stock, the kind of buy orders mutual funds make, even when the funds try to disguise them, then purchase that stock before the mutual fund's order is executed. The fund ends up paying more per share, and the HTF traders pocket the difference.

This isn't illegal; it's akin to cutting into a long line at the supermarket. And it's just as infuriating. One study by the Tabb Group estimates that high-frequency traders made about $21 billion in profits last year—much of that at the expense of mutual funds.

2. Flash orders.
A "flash order" [is] the quick display of unfilled trading orders to a select few insiders. This gives the insider an advance look at a trading price you and I never see. Mind you, it's a half-second advantage; you and I couldn't do anything with it anyway. But those with HFT systems can.

3. Dark pools.
Technology gives privileged insiders an edge in another way—by connecting big players inside exclusive electronic trading venues. Because they are private and trading is anonymous, these secretive venues are known as "dark pools," [where] huge amounts of stock are bought and sold every day.

This gives big players two advantages: lower fees on the actual trades and secrecy. This creates two problems for the rest of us. First, these trades affect the value of stocks you and I own, but they're invisible to those outside the dark-pool set.

Second, if enough trades move to dark pools, they will undermine the significance of publicly available prices on the regular exchanges. That's bad for the economy.

Overhanging this rapid-fire environment is the risk it could create a serious market meltdown by accident. Today, the meltdown risk is compounded because high-frequency traders deliberately probe across various markets—from currencies to bonds and commodities—around the world. So, a meltdown in one market could quickly spread to another, and existing protections could never keep up.

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