U.S. stock markets no longer provide a transparent flow of data for properly pricing stocks. Instead, the system has become a "web of chaos," says Sal Arnuk, co-founder of Themis Trading and co-author of Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio.
As scary as that might sound, there are some observers out there who believe that stock pricing may have improved as a result of these revolutionary changes. Clearly, there is considerable debate surrounding the question of whether or not digitization has been a net winner so far. One thing everyone agrees on, however, is that the changes to our markets have been breathtaking. Here are 10 crazy things you may not know about today's stock market.
1. U.S. exchanges handled an average of 978,963,142 quotes per day in last year's fourth quarter, according to the various "tape plans" that track such activity. How does that look practically? Imagine giant cooled rooms filled with thousands of machines, together pumping out 41,836 quotes every trading second. Never have so many fought so fervently for pennies.
2. High frequency traders sling -- and then milliseconds later, cancel -- quotes on somewhere between 500 and 1,000 tickers each day. HFT firms push thousands of buy and sell offers into exchanges every second. Nanex says the number of tickers subject to this sort of hurly-burly activity is greater than it ever has been. What's that mean practically? Not much: Actual trading volume has declined on the New York Stock Exchange and Nasdaq each year since 2008.
3. High frequency trades have thus far accounted for 53% of stock market volume in 2012. That's down from 55% last year and 61% in 2009, according to TABB Group, an authority on the business of high frequency trading. Still, the ratio is impressive -- and unsurprising. In 1999, Goldman Sachs (NYSE: GS ) entered the computerized trading business when it bought Hull Trading. Today, Goldman and Barclays (NYSE: BCS ) comprise two of the NYSE's six "designated market makers," which are firms that help match buy and sell orders, thus providing liquidity to the exchange. Three of the other four -- GETCO Securities, Virtu Financial, and recently hobbled Knight Capital Group (NYSE: KCG ) -- have substantial high frequency trading operations.
4. The Nasdaq executes and cancels orders in less than 1/100th of a second. For perspective, that's at least 150 times faster than the blink of a human eye. Market participants have always prized speed, of course, but the rise of the sorts of ultrafast market machines that now undergird the Nasdaq can be traced to December 1988 and the introduction of SOES, the Small Order Execution System. Traders would use computers to enter orders under 1,000 shares, which were then executed automatically. The system would go on to inspire a generation of automated digital exchanges.
5. Revenue from high frequency trading in U.S. stocks declined from $7.2 billion in 2009 to $5.7 billion in 2010. And that's even as HFT specialists have grown in power. BATS Global Markets, an alternative stock exchange, accounted for 8% of U.S. average daily trading volume in 2011. High frequency trading operator Dave Cummings founded the firm in 2005. While no longer a key executive at BATS, he still manages Tradebot Systems from its headquarters in Kansas City, Missouri.
6. In high frequency trading, each millisecond gained or lost is worth an estimated $100 million in revenue per year. In Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System, author Scott Patterson tells the story of top HFT firm GETCO paying $300 million to build a fiber-optic connection between a Nasdaq data center in Carteret, N. J., and its operations in Chicago. The goal: shave three milliseconds off the time needed to execute a trade, or (surprise!) $100 million per millisecond.
7. The NYSE operates 500,000 square feet of data center space in the U.S. and U.K. Its largest facility, which it calls a "Liquidity Center," is located in Mahwah, N. J., and has 400,000 square feet of space, a portion of which is set aside for high frequency trading firms to place servers physically near the NYSE's matching engines, reducing the time required to execute an order.
8. For the first time in history, Nasdaq generated more average daily dollar volume than the NYSE in 2010 -- $3.1 billion more, to be precise. The chasm would widen to $8.6 billion the following year, underscoring the importance of electronic exchanges in the business of making markets in U.S. equities.
9. There are anywhere from 30 to 50 "dark pools" of liquidity where institutional investors trade among themselves. Quotes offered on these exchanges aren't public, yet they result in about a third of all U.S. stock trading, TABB Group estimates. Big firms such as Goldman and Credit Suisse created dark pools to protect their trades from algorithms meant to seek out and trade ahead of big orders, effectively "scalping" profits by anticipating the action. Though originally put off by the pools, exchanges have since gotten in on the action. The latest pool, a NYSE pilot project called the Retail Liquidity Program, acts like a dark pool in allowing participants to price stocks in fractions of a cent, a practice the SEC bans on transparent public exchanges. BATS has filed to create a similar program.
10. Market-specific communications disruptions have risen every year since 2007, including at least 110 over the past year, The New York Times reports. One malfunction was so bad that it ironically forced BATS to postpone its own initial public offering. Scarier still: Major exchanges have employed "circuit breakers" for addressing trading glitches since shortly after the 1987 Black Monday meltdown.
So, are the pricing benefits of all these changes enough to offset the challenges created by automated trading systems operating at breakneck speed? Our Foolish series on the near-death of Knight Capital attempts to address this question comprehensively. See all of our coverage in the sidebar on the left of your screen, and be sure leave comments below.