Battling Over the 'Honest Graft' of High-Frequency Trading

NEW YORK (TheStreet) -- There's honest graft, and there's dishonest graft. That's what I learned from the first political science book I ever read, and still my favorite.

In Plunkitt of Tammany Hall, an old ward heeler tells reporter William Riordan about graft. Taking a cut of a bridge's cement contract payment is dishonest graft, he says. Honest graft is knowing the need for a bridge, then buying up the necessary land on either side and selling it to the city at a markup. Dishonest graft is pure self-interest, whereas honest graft is getting rich for the greater good (and the good of the party). Plunkitt himself spent almost 40 years in the New York State legislature, and for decades was a major force in the Tammany Hall political machine in New York City.

Now, more than 100 years later, honest graft is back.

On Monday, the president of BATS Global Markets Bill O'Brien took to the airwaves at Comcast's (CMCSA) CNBC and defended honest graft against Flash Boys author Michael Lewis.

As I wrote yesterday, BATS literally bought the land on one side of the bridge -- well, in this case, a tunnel.

That would be the Holland Tunnel between Manhattan and New Jersey. BATS maintains its computers at 545 Washington Blvd. in Jersey City.

And Bill O'Brien is Plunkitt of Jersey City.

The company's location means BATS' Alternative Trading System gets orders from the New York Stock Exchange on Wall Street before other markets can.

It's a question of microseconds, but that's enough time for BATS' algorithms to push the company's customers ahead of competitors. They know the seller and the price, and bid just a little higher. When willing buyers come in microseconds later they can sell the stock back.

The profit may be less than a penny per share, but with billions of shares changing hands, they get rich and no risk. It pays for a big broker's computer algorithms to trade at BATS.

As Lewis detailed in his book, Brad Katsuyama figured this out, and last year formed an alternative trading system called IEX Group to combat it. IEX has a shoebox filled with optical fiber that delays incoming bids by 350 microseconds. The delay gives all traders the buyer's offer at the same time. It eliminates BATS' advantage.

"Shame on you," cried O'Brien, in the very definition of chutzpah. "The market has always had intermediaries." O'Brien accused Lewis of advertising Katsuyama's trading platform, hinting there may be dishonest graft -- a charge Lewis and Katsuyama immediately denied.

It's important to note at this point that O'Brien and BATS have done nothing illegal.

Like Plunkitt and his Tammany Hall cronies, BATS saw it had an advantage and took it. That advantage was created by the vagaries of fiber optic networks and the speed of light, which can get from Wall Street to Jersey City before it gets to Secaucus or Fort Lee.

Katsuyama's solution is actually a bit like Chris Christie's famous blockage of the George Washington Bridge. He literally delays traffic so all traders will see offers at the same time.

It's time for some fiber traffic problems in Jersey City.

During the CNBC scrum, Lewis was quick to note that the government does not need to solve this problem.

Maybe not. Market forces could solve the problem. The IEX shoebox gives buy-side traders the best possible price by delaying their offers, Katsuyama said. While the difference may be less than a penny per share, that's money buyers would rather hold instead of lose.

According to IEX's web site, almost 19 million shares per day are now trading through its system

The question is not what the government will do, but what BATS will do to bring the buy side back to its exchange.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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