High-frequency trading

HFT has been a hot topic for the last week after Michael Lewis promoted his book on "60 Minutes" and claimed that the markets are rigged.

There's a lot of opinions written on it but the details are often not given.
My knowledge of the market internals are probably out of date, but I'll give a shot at describing what happens for a trade.

A market order from a retail brokerage might be matched internally by the brokerage (ie, your buy order matches somebody's sell order).  If not, the brokerage tries matching your order with consolidators or with dark pools.  If still no match, the brokerage sends the order to a market.
All this happens quickly, typically under a second.

In all the attempts at matching, who sets the price? This is were HFT comes in.

Decades ago, there were human "market makers" who who set the price based on supply/demand of stock trading. Really long ago, prices would be posted on

blackboards by aides every hour or so.

Now prices are set by software and updated in a fraction of a second.  Every trade might change the price. HFT firms compete by have the fastest speed at price detection.

There are 3 government rules that limit price setting:
1) NBBO (National Best Bid/Offer)
2) decimalization
3) regulation NMS

NBBO says all of the national markets have to be shared so that brokerages can
pick which brokerage will get an order. HFT firms try to be faster than the NBBO network so they can find imbalances.

The decimalization law says that stocks must be priced in cents, but dark pools allow trading in fractions of pennies. HFT firms try to find pricing differences
between markets and dark pools.

Finally, regulation NMS uses the NBBO to require that current price settings are

not sent to anybody before it is sent to everyone (via a security information processor). HFT firms discovered they could find a price quicker if they actively probed for prices than wait for the slow SIP network.

(Reg NMS: Warning 500+ pages of mind-numbing)

http://www.sec.gov/rules/final/34-51808.pdf

Reg NMS started in 2007.  That’s when high-frequency trading really started.

So the markets are "rigged" because the laws don't make sense in an era of fast

computers and networks.  It's like applying laws for horse&buggies to automobiles.

HFT firms were really profitable 5 years ago. Now the competition between HFT firms has dropped profits by ~80% as they fight for smaller and smaller sub-penny profit/trade.

I'm not concerned about HFT.  For the average person, the difference is less than

a penny per share and there are other things that have a much bigger effect.

If you are worried, then use limit orders so you can specify the price you want.