The authors begin their introductory chapter stating that gone are the days when the primary purpose of stock market was capital allocation. Instead, they say,

The primary purpose of the stock exchanges has devolved to catering to a class of highly profitable market participants called high frequency traders, or HFTs, who are interested only in hyper-short term trading, investors, be damned

Indeed if one looks at some of the basic numbers that drive volumes, it is clear that HFT firms have become exchanges’ biggest customers.

  • HFTs account for 50–75% of the volume traded on the exchanges each day and a substantial portion of the stock exchanges’ profits.
  • While smaller HFTs churn hundreds of millions of shares per day, a few of the larger HFTs each account for more than 10% of any given day’s trading volume.
  • HFTs earn anywhere from $8 billion to as much as $21 billion a year that comes at the expense of long-term investors

Gone are the days when human dealers / human specialists were the people involved in market value discovery of any stock. Today the asset pricing in the stock is largely a result of a high frequency algorithmic automated trader.

The authors say that one of the main reasons for writing this book is to expose the HFTs and the way they are colluding with the exchanges to wreak investor confidence. They are worried that the very foundation of markets – investor confidence is at stake.

A retail investor a few decades ago was mainly concerned with the bid ask spread and executional risk (if it is a limit order). However in today’s world, the same retail investor is facing a much bigger and grave problem, i.e., his order is being sold to hyper efficient HFT firms. These HFT firms then either front run or use strategies that generate profits at the expense of the retail investor. The common argument favoring HFT players is that bid ask spread has come down. However this is the case only for 5% of the actively traded stocks. For the rest 95%, the spreads have become wider.

Chapter 1 – Broken Markets

The chapter starts off by saying that stock market used to be single unified place for investors. Now it is a connected mess of more than 50 exchanges, dark pools and alternative trading venues. The market is like a shattered vase held by weak glue – HFT firms.

The stock market has changed dramatically in the last 15 years. Specialist executing a trade at NYSE and an electronic dealer at NASDAQ were primarily responsible for the final execution. With the technological advances, one class of participants has grown extremely big in size, HFT players. When did HFT start?

The authors trace the HFT to Instinet. Instinet was the world’s first electronic brokerage firm, that was order driven, anonymous and no specialists to facilitate order flow. Instinet began courting a new type of customer who promised large volumes in exchange of Instinet’s top-of-book and depth-of-book data. What these firms did was to use quote matching strategies to rip off uninformed block traders. They fed the data in to algorithms that gave the probability of seeing an uninformed vs. informed trade. Based on these probabilities these firms either front ran the block orders or provided liquidity. Basically they were using quote matching strategies to make money from these strategies and they generated massive volume at Instinet. But the thing that got HFTs to explode was two pieces of regulation:

  • Regulation ATS – This mandated all orders go to a public quote. With this the automated traders had the entire ocean in front of them to use their predatory strategies
  • Reg NMS – This created the concept of NBBO (National Best Bid and Offer) that made all the exchanges route the order to the venue that quoted NBBO.

With these two regulations in place, “Speed” became the key differentiating factor amongst various exchanges. These changes turned the market from an investor-focused mechanism that welcomes traders and investors TO a sub-second trader-focused mechanism.

The brokers who enticed retail investors in to trading at low commissions, actually made money by selling them to HFTs who in turn made money by trading around the order flow. Do HFTs act as specialists? Given the recent crash, it definitely looks like a NO. These firms are the first one to demand liquidity instead of offering liquidity in times of stress. Even worse, they might even disappear and stop trading for a few days and stop offering liquidity altogether (that might make the fragmented market even more fragile).

Chapter 2 – The curtail pulled back on HFT

This chapter talks about how HFTs predatory practices became known to a much wider audience. The defining characteristics of a HFT firm are:

  • Large technological expenditures in hardware, software and data
  • Latency sensitivity (order generation and execution taking place in sub-second speeds)
  • High quantities of orders, each small in size
  • Short holding periods, measured in seconds versus hours, days, or longer
  • Starts and ends each day with virtually no net positions
  • Little human intervention

The privatization of exchanges and their hunger for volume was perfect for HFT players.

High frequency traders need high-computing power and ultralow latency (high speed). They get it by renting server space from the stock exchanges. They also need to access big amounts of data, which they analyze and run though algorithmic trading programs to detect patterns in the markets. They get the data from the stock exchanges, too. Then they trade, capitalizing on those patterns. And, in many cases, the exchanges pay them to trade.

The chapter talks about four strategies that HFT firms use to make insane amount of money

  • Market marking Rebate arbitrage
    • Exchanges reward HFT firms with rebates for providing liquidity
    • Even if the firms buy and sell at the same price, the exchange rebates made Designated market makers very successful
    • Exchanges allowed parity and it enables them to buy alongside other customer orders
  • Statistical Arbitrage
    • With explosion of ETFs, stat arb generated tremendous volumes for the exchange and huge profits for HFT players
  • Latency Arbitrage
    • The two speed market – SIP vs. the NBBO direct data feed clearly made the information asymmetric.
  • Momentum Ignition
    • Pump up the momentum artificially

It ends with a list of events (arrest of a HFT programmer from Goldman), media articles and popular TV shows that made HFT’s predatory practice known to the vast majority of investors.


Chapter 3 – Web of Chaos

This chapter traces the history of US stock market and recounts the developments that took place that led to a fragmented market. It begins by explaining a strange phenomenon that the authors witnessed as agency traders. Whenever they submitted an order to the exchange there were three activities that were seen in the order book

  • Quote flickering – bids or offers would mysteriously rise or disappear
  • Penny jumping – somebody already had this information and were using against the order
  • More impact on prices

As agency brokers, they were stunned to see that the so called healthy market of 50 competing exchanges were actually making them worse off. What they realized in their investigation was that the market has become one big conflicted, for-profit web of more than 50 trading destinations. What’s the impact on a retail trader or an agency trader? The authors say :

  • If you are a retail investor, there’s a reason why your online brokerage firm charges you only $8, or even nothing, for your orders. It’s because they sell your orders to HFT firms that make money off of you.
  • If you are a professional investor, there’s a reason why your brokerage firm charges you only a half a penny a share if you use a volume weighted average price (VWAP) or percentage of volume (POV) algorithm to execute your trades. (Algos slice a large order into hundreds of smaller orders and feed them into the market.) It’s because your orders are fed to proprietary trading engines that make money off of you. Their algo figures out how your algo works, forcing you to pay more for buys and receive less for sells.
  • And if you are an agency broker, like we are, there’s a reason why some big brokerage firm salesmen offer their VWAP algo for free! It’s because their firm has a way to make money by disadvantaging your orders all day long.

The authors strongly believe that 50 destinations on which the orders are traded and the complexity exist for two reasons

  • To maximize your interaction with HFT in a way that disadvantages you
  • To maximize HFT ability to collect exchange rebates

The chapter gives the history of NYSE, NASDAQ, SOES, Instinet, Archipelago, Direct Edge, BATS and recounts the wave of consolidation between various exchanges and ECNs. Today the US has 13 exchanges, 10 of which are owned by Big Four

  • NYSE, NYSE Amex, and NYSE Arca (3)
  • BATS and BATS Y (2)
  • EDGX and EDGA (Direct Edge) (2)

Besides the above 10 exchanges, there has been a proliferation of dark pools and alternative trading systems. The main reason for this mushrooming of these avenues is that it benefits HFT in four critical ways

  1. Exchange Arbitrage – Guys who have speed and technology on their side can arb away the differences between various exchanges. This argument actually has a flip side to it. HFTs want more destinations and hence market is going to be more fragmented with new trading avenues catering to these players.
  2. Rebate Arbitrage – The maker-taker pricing models used by exchanges are perfect for HFT as they have become masters in jumping the queue.
  3. Fragmentation – Each exchange sells tools and data feeds that benefit the exchanges. At the same time it enables HFTs to be jump the queue.
  4. Dark pools serving a conduit through which investor orders can be internalized by brokerage firms.

The takeaway from the chapter is that enormous competition amongst trading avenues has not led to “executing a trade efficiently and in cost effective way”, but has led to “trading around investor orders”.


Chapter 4 – Regulatory Purgatory

This chapter starts off mentioning a research paper that was published on NASDAQ in 1994 that showed that the market makers were avoiding odd-eighth quotes. This research report shook the entire US investor confidence as it exposed the fact that the biggest stock markets in the world were conducting business much like a mafia. The SEC was put on the defensive and it had to act. What then followed were a series of regulations that have completely changed the way instruments are traded in US. The chapter lists down some of the key aspects of these regulations:

  1. Order Handling Rules ( Through these rules, the SEC shut down the private market that brokers and institutions were using to trade )
    1. Display rule that made market makers and specialists to display publicly the limit orders they receive from the customer when the orders are better than the market maker’s or the specialist’s quote.
    2. Quote rule that made market makers and specialists publish the best prices at which they are willing to trade. No longer can a market maker or specialist hide a quote on a private trading system
  2. Regulation ATS – Force all ECNs to display all their orders to the public
    1. Seeing the orders was a major win for HFT traders. They could model order books and predict prices with much greater certainty
    2. Up until this time, trading algos, which sliced up block orders and fed them piecemeal into the market, were primarily used by sophisticated quantitative traders. With Reg ATS and more quotes being displayed, algos were about to be used more widely by institutional investors.
  3. Rule 390 annulled – This rule prevented member firms from trading NYSE listed stocks away from the trading floor
  4. 1997 -2000 : Decimalization
    1. Quote size reduced
    2. Shortsale uptick rule became useless because it took a penny to move a stock back in to compliance
    3. This wiped out many small mid-cap market makers. That roles was filled by HFTs who have none of the affirmative and negative obligations that specialists and NASDAQ market makers had
  5. Demutualization of NASDAQ in 2000 and NYSE in 2006( change from net trading to transaction based models)
    1. Suddenly it became a volume game
    2. Attracting traders who get volumes became priority and HFT traders became priority clients
  6. SEC published Reg NMS in Feb 2004, its most devastating regulation. Out of the four parts of the proposal, the trade through proposal met with heavy criticism and SEC gave it. It modified Trade through proposal in to Order protection rule. The Order Protection Rule would protect only quotations that were on top of the book and electronically accessible. If the NYSE wanted to be part of the NBBO, then it would have to change from a “slow” market to a “fast” market

These 6 pieces of regulation over a period of 10 years have changed the face of trading forever. From 1997 to 2007, the SEC had fully changed how the equity market functioned. Volumes in listed stocks exploded as competing market centers began fragmenting liquidity. Because the NYSE was becoming obsolete, so was the block trade. Average trade sizes plummeted, as orders began to get chopped up by institutional traders seeking to cloak their larger orders from fast HFT traders. Spreads did shrink, but so did the amount of displayed liquidity in the best bid and offer. The new equity market had arrived, and it was about to wreak havoc on every investor.


Chapter 5 – Regulatory Hangover

After the flash order controversy became known to a wider audience in the summer of 2009, SEC came under fire and issued two proposals, one on stopping flash orders and second on regulating dark pools. Unfortunately, even though proposed in 2009, the SEC has yet to approve any parts of either proposal. Flash orders are still legal and dark pools are still gaining market share. The two-tiered market that the SEC feared in 2009 is alive and well and growing every day. The US markets were rocked with flash crash on May 6, 2010 and it showed the fragility of the US systems. Since the Flash Crash, rather than address the entire fragmented equity market, the SEC proposed and approved a number of short-term band-aid fixes such as

  • Single stock circuit breakers
  • Elimination of Stub quotes
  • Sponsored access rule
  • Large trader reporting rule
  • Consolidated audit rule


Chapter 6 – The Arms Merchants

The authors compare the US stock markets to arms merchants who supply weapons but never get caught in the cross fire. Since demutualization and fragmentation of markets, the revenue mix of the exchanges has completely changed. Nearly 75% of the revenues come from 2% of the clients – HFTs. So, the exchanges are bending over their back to provide products and services to these 2% of clients. The stock market companies have also changed the way they look at themselves. They no longer think that they are the venues for capital allocation decisions, but position themselves as a “technology company”. The revenue from listings business has come down dramatically and revenue from transaction based fees has become very high. Also the nature of the market is changing. In 2011 there were 302 ETFs listed vs. 125 IPOs. The exchanges had to look out for alternative ways to generate profits. The chapter describes four of the products and services that exchanges have introduced that has changed the way trade is executed today. They are

  • Colocation
    • NYSE center consumes 28 MW of power, enough to run 4500 residential homes. Its equivalent to 7 football fields
    • NASDAQ doesn’t own its data center. It chooses to lease out from third parties;
  • Private Data feeds
    • The granddaddy of all data feeds is NASDAQ’s ITCH, which was developed by the Island ECN, which, in turn, was developed by Datek Securities, a SOES Bandit brokerage firm. Many other exchanges and ATSs around the world, including the London Stock Exchange’s offer private data feeds based on the ITCH protocol
  • Rebates for order flow – The Maker/Taker Model
    • This is at the core of equity market structure problem.
    • It has influenced how most broker-sponsored smart order routers access liquidity. Institutional investors typically enter their algorithmic orders into a smart order router, or SOR, provided by their brokerage firm in exchange for a low commission rate. The “algo” chops up large block orders of 100,000 shares, for example, and doles out small slices of say 100–500 shares each that are routed to various market centers. The purpose is to minimize market impact. However, some orders are not routed to the destination where best execution would dictate, but to the destination where the broker receives the best rebate. While these SORs may be “smart” for the broker, they may be pretty dumb for the client.

The above changes make the stock exchange a completely different animal.


Chapter 7 – It’s the Data, Stupid

This chapter talks about the nefarious ways in which stock exchanges are selling out ITCH data feed revealing information about hidden orders. By creating a data feed structure that makes it easy for an HFT firm to track hidden large orders, the exchanges are working hand in glove with HFT players in ripping off retail and institutional clients. The authors investigate the ITCH feed from NASDAQ, BATS and other exchanges and find that there is a lot more information that is being systematically sent out to HFT firms.

Another area where exchanges are playing to their clients tunes is the computation of indices. With one in three trades being executed away from primary exchanges, all the indices are actually phantom indices. They are misrepresented and this gives a fantastic opportunity for the HFTs to arb that difference. This problem can be easily fixed by to accurately reflect all traders intraday in a timely manner. But it’s not being done. This is a clear case of exchanges setting aside investor interests and entertaining HFT clients.

Machine readable news data feeds are also another development in this crazy tech arms race. The algos read the news and spit out trades. The authors cite just one of the many incidents that have led to an increased volatility in the markets.

Chapter 8 – Heart of Darkness

The chapter starts off by highlighting the example of one of the largest dark pools, pipeline that swindled money in the name of anonymity. Dark pools came in to satisfy the demand of institutional traders who wanted anonymity while trading large blocks. Pipeline advertised anonymity but at the same time established a HFT firm to work around the trades and profit from the dark pool. Dark pools / crossing networks served a genuine need when they came in to existence. But with regulatory changes and the developments in the US market, they have actually become lit pools. All major brokers in the name of internalization feed the owners’ desires for greater revenue, cost reduction and most damaging to investors – prop trading.

The chapter also talks about latency arbitrage strategies that HFT players use. Typically a dark pool pricing is 10 to 15 milliseconds behind real-time prices that HFT firms use. This creates a two tiered market where the privileged few are ripping off institutional orders.

In December 2010, SEC Chair Mary Schapiro testified before Congress that the Commission was looking into “abusive colocation and data latency arbitrage activity in potential violation of Regulation NMS.” At the close of 2011, however, there had been no action on this subject, and the SEC’s own 2009 Dark Pool Proposal is still sitting in limbo. Almost all the dark pools in existence feed/benefit prop trading as their primary intention. Will there be a regulation on it?


Chapter 9 – Dude, Where’s my order ?

This chapter talks about the path that an institutional order goes through in the new web of chaos. The market has become so complex that under the name of SOR, the order actually travels around ECNs, dark pools and a host of other venues before getting filled.


All this complexity makes one wonder whether client should replace the full form of SOR from Smart order routing to Sub optimal order routing. Is there a choice? Looks like NO. In today’s world the buy side trader has not much clue how his order is going to be filled. Once he chooses one of the algos to execute( VWAP, TWAP, POV, close-targeting algos, arrival-targeting algos, Dark liquidity seeking algos, etc), the HFTs take over the order. Nowadays buy side traders spend an enormous time policing their order execution process. Shouldn’t they be spending time on generating alpha rather than policing the execution ? Or is the execution the only alpha left in the market ?

Chapter 10 The Flash crash + Chapter 11 The Aftermath

The next two chapters are guest chapters written by R.T.Leuchtkafer. The basic takeaway from these chapters is that HFT scalpers have become the new middlemen in the market and they are an unregulated lot. They act as liquid supplier and liquidity demanders according to their own profit motives. They have no obligation to make market continuous. In fact as the flash crash illustrates, they are the first ones to run away in the times of crisis. These chapters have a tone of disappointment with SEC. Two and half years have passed since the flash crash and no great measure have been put in place. The BATS IPO failure is an example that illustrates that markets are still very fragile and the next flash crash can happen anytime.

Chapter 12 – Killing the stock market that laid the golden eggs

This is a guest chapter authored by David Weild and Edward Kim, who say that IPO markets have been battered mainly because of Reg ATS. The main point of the chapter is that spreads have become so low that only a few large cap, high volume stocks are able to profit from the stock exchanges. They draw a parallel between roads and stock exchanges. Roads collect optimum tolls to fund other development activities. In a similar way, the investors should be charged higher commissions to trade to bring back the market to favor IPOs. Will this happen ? Once investors are used to low commissions, will they pay high commissions? I don’t think so.

Chapter 13 – Call to Action

The authors say that the only way to restore the market confidence is to create a parallel market where there are human market makers with wider spreads, with obligations on market makers to maintain price continuity etc. This is like going back to the world of duopoly NYSE-NASDAQ. Will such a recommendation be taken seriously and acted upon? I think it is very unlikely such a thing will happen.

The authors list down a set of demands from the regulators

  • Ability to opt-out of private data feeds
  • Eliminate the speed differential between the slower public SIP and faster private data feeds
  • Eliminate Phantom indexes
  • Real-time identification of which dark pool traded a stock
  • Eliminate the maker/taker exchange model
  • Introduction of order cancellation fee

The appendix to the book gives all the papers from Themis trading that were widely quoted in the media.



US Markets are broken. What does that mean? When did it happen? How did it happen? Who allowed it to happen? These questions are succinctly answered in the book. This book needs to be read by anybody interested in markets as it shows how adverse changes in market microstructure can wreak havoc with the entire financial markets. Given that there have not been any significant regulatory changes since the flash crash; the next one could be any day from now. Reading this book makes you believe that many crashes will happen sooner than later (if nothing is done to remedy the current state of broken markets). Knight capital demise is a case in point.