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How to 'unrig' markets

I have to applaud Michael Lewis for a superb read in "Flash Boys: A Wall Street Revolt" — and for sparking the conversation about high-frequency trading. I have been saying for years that there are advantages given to HFTs that are, at a minimum, detrimental to investors, and at worst, a violation of securities law.

In his "60 Minutes" interview, Michael Lewis said, "The market is rigged." The way I see it, if we can fix two key problems with HFT, we can unrig the market.

The speed advantage

High-frequency traders pay up to $60,000 per month* to collocate servers in Carteret, NJ so they can get the Nasdaq feed directly from the source. Unfortunately, anyone who is not a participant in the HFT game gets their prices from data that are transmitted from Carteret to Mahwah, NJ, some 40 miles away. (For more technical detail, check out this animation.)

This unfair advantage gained by the HFTs enables them to trade on the real market in real time, rather than the rest of us who trade at an unknown number of milliseconds later. As in the movie "The Sting," the HFTs are seeing what's real as it happens, while we are seeing the results of a horse race that has already been run.

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Giving HFTs this advantage means that the trade-execution quality that brokerages must provide to customers and regulators is flawed.

The solution is unbelievably simple: Make exchanges put all HFT direct-feed users on an equal footing with the SIP. Treat the SIP as if it were another HFT customer, forcing all customers to be the same distance away. In the case shown in the animation, that would involve a 40-mile fiber-optic spool. Also, the original timestamp must be preserved all the way to SIP subscribers.

The fake out

Here's the other big problem: The HFTs create and cancel hundreds of billions of quotes per session.

In 1999, there were 1,000 quotes per second streaming from U.S. stock exchanges and about 2 billion shares traded each day. Today, there are 2 million quotes per second but the market trades just over 5 billion shares per day. So, we are seeing just over twice the volume of stock traded, but 2,000 times more quotes — quotes that are essentially HFTs at war with each other.

In other words, the HFTs generate a crushing, expensive amount of information (data) that don't need to be sent to millions of computers around the world. They spend a vast majority of their time spoofing, or trying to fake out algorithms of other HFTs. As Michael Lewis said, the HFTs give these spoofing algos scary names like Ambush, Nighthawk and Raider.

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Now the issue isn't just that the algos are attempting to manipulate markets higher or lower, which should, of course, be a concern to the regulators. But primarily this "quote stuffing," sending millions of spoofing quotes per minute, effectively blinds real traders the same way throwing a handful of sand into an opponent's face would cause them to not see clearly.

The solution here is quite simple as well: Simply bring back the designation "non-firm quote" to trading. Thus, orders that the submitter intends to leave for at least one second would exist as they do today. Orders that someone wants the option of canceling in less than a second must be marked non-firm and thus could be ignored by the market. Non-firm quotes would not set the national best bid and offer (NBBO) .

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Firms that trade fast shouldn't scare investors or rig markets. But HFTs have made billions off the backs of Joe & Jane investor as well as mutual funds, pensions and institutional clients. They haven't done it by being smarter and playing within the rules, but by being smarter and playing outside the rules. If we take away the "edge" they've illegally obtained (regulations say what I've described above is against security laws) then they will stop being a threat.

Note: The author recognizes and thanks Eric Hunsader and Nate Rock of Nanex for their insight and assistance with this article.

"Fast Money" trader Jon Najarian is a professional investor, money manager, media analyst and co-founder of optionMONSTER and tradeMONSTER. He worked as a floor trader for 25 years and before that, he was a linebacker for the Chicago Bears. Follow him on Twitter @optionmonster.

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