Now that we know what High Frequency Trading (HFT) is, let’s look at the circumstances that led up to the current state of affairs where over half of the trading volume (total number of trades per day) executed through our exchanges are now effected by HFT.
How Could This Happen?
Like many other unintended consequences predatory high frequency trading (HFT) was made possible by regulatory action meant to protect investors. Electronic trading was originally implemented in the late 80’s to ensure that investor orders would be executed in a timely manner even if human market makers were unavailable or hiding (i.e. Black Monday when traders just stopped answering phones so investors couldn’t continue to sell securities). Since then electronic trading in general has been considered a very valuable technological advancement allowing faster and more accurate trade execution and lower trade costs, but it isn’t without issues.
As electronic trading replaced the human element on all exchange floors, it became harder to control pricing fairness between investor and trader. There are 13 major exchanges in the United States including the well-known New York Stock Exchange, plus many small off shoot exchanges, so altogether there are around 50. As a result a security, say GE stock, may be offered for sale on many exchanges at the same time at many different prices. Over the years it became increasingly difficult to tell if one was getting a good price for a security or not. Regulation NMS was the SEC’s attempt to create a consolidated marketplace with fair pricing, more accurate quotations, and more timely data for all and they largely succeeded.
What regulators didn’t anticipate was the ingenuity of some of the firms they allowed to access these new consolidated systems in the name of liquidity. Once HFT firms realized they could see securities prices even ahead of the Security Information Processing (SIP) system and that they could easily manipulate those prices for profit, it didn’t take long for some unscrupulous people to exploit the situation. TA DA! Predatory High Frequency Trading was born.
Some Wall Streeters, pundits and commentators when asked about the resulting price manipulation still insist that this practice is just another example of good ole capitalism at work, that it doesn’t really affect the small investor and that we shouldn’t fault people for being smart enough to take advantage of such a fantastic and profitable free market opportunity.
Others, including Michael Lewis the author of Flash Boys, make high frequency traders out to be downright evil. I think the truth is somewhere in between, but I still can’t condone or appreciate a practice that hurts my industry’s already tarnished reputation and creates more distrust among the American people, regardless the amazing “ingenuity” of some firms.
So, What’s the Answer?
There is no specific rule against predatory HFT practices, so legal action is not really an option. More regulation is always on the table, but is that really the answer? In my opinion, more regulation could actually cause more unintended negative consequences instead of solving the problem.
However, if Regulators feel they MUST do something to save face, and they usually do, perhaps they could tweak existing rules instead of reinventing the wheel. Of course, that would mean that HFT firms would have to be registered with the Securities and Exchange Commission (SEC) so they could monitor them. Currently there is no requirement to do so.
That may change soon. Just last week, Mary Jo White, Chairwoman of the SEC, announced that they are considering forcing HFT firms to register. While I don’t think more regulation is THE answer, this may be helpful as a way to force more transparency and put us all on a more level playing field.
Once registered, HFT firms may be held to same standards as the rest of us. There is already a rule against something called “Front Running” that applies to me and my peers that trade stocks on behalf of clients. As a licensed or registered investment advisor we are not allowed to trade our own personal accounts ahead of our clients to take advantage of a fast moving market. We must make best efforts to put our client’s trades ahead of our own, try to obtain the “best” price available for them and only after all their trades are executed should we buy or sell the same security. Any advisor who purposely Front Runs could be fined or have their licenses taken away. Predatory HFT works in much the same way as Front Running and it’s not unreasonable to think that the SEC may be able to find a way to apply similar rules to HFT firms.
Congress is getting involved as well. As I write, there is a Congressional hearing taking place that includes various Wall Street insiders, HFT opponents & proponents and other major players in this saga. I don’t know about you, but I usually don’t put too much faith in what comes out of these hearings. They always seems to serve political interests more than ours.
The good news is that there is one promising solution that doesn’t involve more regulation or government intervention. It’s a free market, technology driven solution to a free market, technology driven problem and it’s already making a big difference.
Join me next week to find out what it is and how you can be part of the solution.