Reasons to fear Wall Street's high-tech traders

June 22, 2012: 5:00 AM ET

A review of Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System, by Scott Patterson.

By Scott Cendrowski, writer-reporter

FORTUNE -- Remember the flash crash? On May 6, 2010, the Dow Jones Industrial Average plunged by 600 points over a couple of minutes. Procter and Gamble (PG), the $165-billion consumer giant, lost 37% of its market cap within seconds. Accenture (ACN) and Exelon (EXC) dropped to a penny a share. All hell seemed to be raining down.

In the next instant, everything was back to normal. The market regained almost all of its losses. Problem was, no one could explain what had just happened. It didn't matter if you were Morgan Stanley's favorite client, there just weren't answers.

Journalists eventually pieced the story together. It turned out that a mutual fund company in Kansas had set off a chain reaction of selling by placing a single order in the futures market. In some ways, this explanation was more terrifying than our previous state of ignorance. Had the U.S. stock market come to this? Crashing because a Kansas butterfly flapped its wings?

In Dark Pools, Wall Street Journal reporter Scott Patterson explains how we got into this mess. The Flash Crash was the first major symptom of a problem that has been spreading across Wall Street for more than a decade. High-speed traders, dubbed high-frequency traders because they trade in and out of stocks thousands of times per second, have overtaken the stock market.

On the one hand, they provide constant liquidity so regular investors don't get charged egregious spreads by middlemen -- the so-called market makers -- at Nasdaq or the New York Stock Exchange. On the other, their opaque technology has given us episodes like the Flash Crash.

Patterson, a wonderfully numerate financial journalist, is good at ferreting out vivid stories about high-speed trading, the Street's newest infatuation. His previous book, The Quants (2010), was a rich narrative about the new world of quantitative traders -- guys who let computer algorithms do the hard work of trading. In Dark Pools he zeros in on the market plumbing that has allowed quants to jump in and out of stocks in microseconds (millionths of a second).

The plumbing was first built by an unlikely alliance between Staten Island traders and a programming nerd named Josh Levine. Eventually astrophysicists joined in. Together, they retooled the U.S. stock market into a speed machine unlike anything ever imagined.

How does all this impact everyday 401(k) investors? High-frequency traders place hundreds of thousands of orders each second. They are constantly on the prowl for small opportunities. So let's say your mutual fund manager at Fidelity is buying 50,000 shares of Exxon (XOM). We'll assume that the stock trades for $75.20. He won't place the whole order at once, instead buying piecemeal in 1,000-share blocks.

After he buys 1,000 shares at $75.20, the high-frequency algorithms sense that some big investor is buying Exxon. So they also start buying Exxon, pushing the price up to $75.22 and higher. The Fidelity manager then buys another block of shares at $75.25. The high-frequency traders swoop in again and push the price up to $75.30. By the time the Fidelity manager buys his last batch of 1,000 shares, Exxon is all the way up to $75.50. That means the manager lost $250 on the last block by buying Exxon at $75.50 instead of $75.25. That $250 should have been invested for you and, estimating a conservative return over 40 years, grown to $2,500.

Patterson skips across the high-frequency landscape in an engaging narrative that tracks this new world's blinding growth and its perilous consequences. He follows the Michael Lewis formula of finding little-known heroes to explain complex financial maneuvers. One is Levine, a meek programmer who basically invented modern day electronic stock markets from an office on Broad Street in Lower Manhattan stuffed with trash and pet turtles swimming in a pool, not to mention an Israeli bazooka standing in the corner.

In the 1990s, Levine started an electronic exchange called Island to fight what he saw as unfair monopolies in the New York Stock Exchange and Nasdaq, which used market makers to execute stock orders. Problem was, the middlemen colluded to skim huge spreads off of each order.

Patterson quickly gets to the irony: In order to build an electronic exchange without middlemen, Levine needed high-frequency traders to provide liquidity for buyers and sellers. Eventually other electronic exchanges -- called pools -- started forming. High-frequency traders became the new middlemen, providing the trading volumes the pools needed to survive.

Case in point: One day a morning meeting went long at Getco, a high-frequency trading firm in Chicago. Five minutes after the start of trading in New York, a frantic Island official called asking why Getco wasn't trading yet.

This new world of electronic pools of stocks eviscerated demand at the Nasdaq and the venerable New York Stock Exchange. In its halcyon days, NYSE hosted 90% of U.S. stock trading. Today, it handles a quarter.

What's next? Patterson is only sure that the high-frequency trend will continue. He writes about a company called Spread Networks building a super-fast connection between the trading hubs in Chicago and New York, a $300 million project to lay fiber optic cable straight into a Nasdaq data center in New Jersey. The upshot? Cutting 3 milliseconds (three one thousandths of a second) off of the round trip of a trade.

Dark Pools is easily the most entertaining and accessible book to cover the new world of stock trading, even though Patterson's title is misleading. He uses the umbrella term to describe the entire U.S. market, although dark pools are technically sub-markets that mask buy and sell orders from public view.

A bigger problem is that Patterson doesn't explain what will prevent high-frequency robots and advanced-learning algorithms from causing the next market collapse. It's one thing to detail the scary new reality in which these forces drive our stock market. It's another to offer solutions.

That's because there are no easy fixes. The SEC is woefully behind in regulating, and individual high-frequency traders aren't problematic, just as one bad bank won't cripple the system. We may have to wait until his next book to learn how you police the new Wild West, more commonly known as the U.S. stock market.

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