Dangerous and predatory high-frequency trading is bad for markets, bad for regular people and bad for society.

Wall Street's High-Tech Rip-Off

By Marshall Auerback

A brand-new book by Michael Lewis, author of Liar’s Poker and Moneyball, has set the media on fire. In Flash Boys: A Wall Street Revolt, Lewis argues that not only do the liars on Wall Street play poker, but the poker game itself is completely rigged against the little guy.

You, my friend, are the little guy. So am I. And so is everyone else who does not have access to a supercomputer.

Lewis contends that the U.S. stock market — you know, that famous system which impacts how much money is in your 401(k) — is rigged in favor of high-speed electronic trading firms, which use their advantages to rip off investors to the tunes of billions of dollars a year. These firms engage in a widespread practice known as high-frequency trading (HFT). Let's explore why this is very bad for you and me. (Be sure to check out Lewis' 60 Minutes interview, which also features young Brad Katsuyama, the Canadian trader who helped suss out the problem.)

What the Heck Is High-Frequency Trading?
High-frequency trading is trading on steroids. It has exploded onto Wall Street over the last decade, now accounting for 60 percent of the equity action. The firms that do it typically use super-fast computers to post and cancel orders at rates measured in thousandths or even millionths of a second to capture price discrepancies — and that’s how the profits roll in. The practice attracted the attention of regulators after the so-called "flash crash" in May 2010, when the Dow Jones Industrial Average briefly lost almost 1,000 points and scared the crap out of everyone.

Right now, both the Federal Bureau of Investigation and the NY State Attorney General, Eric Schneiderman, have started investigating whether U.S. stock exchanges and alternative trading venues provide improper advantages to high-frequency traders.

Financial “Innovation” Is Very Expensive for Main Street
Wall Street loves to brag about its innovative capacity. But somehow, that innovation often points to one outcome: Main Street gets ripped off.

By simply monopolizing a huge chunk of the stock market’s volume, big firms that engage in high-frequency trading generate very nice profits for themselves. But why should they be allowed to have this advantage? Capturing minute price disparities hardly seems like the reason we set up capital markets in the first place. In the old days, these markets existed for the purpose of providing capital to Main Street to help the latter grow and create more jobs and prosperity. But not all innovation in finance is useful, not all trading plays a useful social role, and a bigger and faster financial system is not necessarily a better one.

High-frequency trading undermines our financial system in a number of ways. For one thing, it’s bad for market transparency, because institutional investors tend to divert some of their trades to what folks in the finance community call “dark pools.” In these privately run stock markets, traders conduct business anonymously and they escape proper regulatory oversight.

A lot of high-frequency trading is done by small proprietary trading firms, which are subject to less oversight than brand name financial institutions. That provides even greater scope to rip off retail investors. Then there’s the unethical practice of “front-running,” which happens when traders are able to purchase orders in front of you and then sell them back to you when you want to buy. The sheer speed of these high frequency trades makes front-running much harder to prove. Finally, high-frequency trading breaks down trust in markets. Thanks to recent high-frequency-trading-related debacles like the flash crash and Kraft’s first trading day at NASDAQ, when its initial trades had to be cancelled, retail investors are wary—and rightly so.

So what if you tend stay away from the stock market? Why should you care what a bunch of nerds are doing with supercomputers? Well, if you hold a 401(k) account or you have a pension, you’re probably caught up in this game whether you like it or not.

High-frequency trading might just drive up the price of stocks a penny here and a penny there in the short run, but over time, it’s going to make a difference. That 8 percent you should have earned becomes 7.9 percent. In one year, that doesn’t matter. In 20 or 30 years, it certainly does, perhaps tens of thousands of dollars worth. The money skimmed off by high frequency traders is money you can’t reinvest. What you lose, they win.

Ultimately, this steroid-trading is self-defeating because if the public continues to think the game is perpetually rigged against them, they won’t bother placing their chips in the casino any longer. (In fairness, my analogy is probably unfair to Vegas, since the house occasionally does lose and the government is not expected to backstop the losses. Plus, the casino industry as a whole is probably better regulated than Wall Street these days.)

Let’s Ban High-Frequency Trading
High-frequency trading should be banned because it’s bad for markets, bad for regular people and bad for society.

Anybody interested in the functioning of markets should be worried about high-frequency trading, because it has the potential to cause market crashes that could vaporize trillions of dollars of wealth. Even if you are a devout believer in so-called free markets, you’d have to be against something that gives one trader an advantage over another. How is there any real competition when both sides are clearly not armed with a high-powered computer that buys access to the price of a product 2 seconds before anybody else?

As we’ve discussed, those dark pools that let traders buy and sell stock under the radar make a mockery of transparency. Neither buyers nor sellers should have private information that can be hidden, just as when you go to a bank to borrow money, the bank knows everything about your project, and you aren’t allowed to hide any negative information nor embellish positive information. Those are the rules everyone else is expected to play by in the financial realm. Why should Wall Street traders be exempt?

High-frequency trading rips off ordinary people who rely on their 401(k)s and pensions for a decent retirement. Wall Street has been making a killing soaking these precious funds in a variety of ways for several decades now, and it’s time to tell them we aren’t going to stand for it.

In the big picture, high-frequency trading is really bad for society. Profitability is not equal to soundness, and the fairy tale that market forces will do most of the job of weeding out unsustainable and harmful business practices vanished with the crash in 2008.We need to remember something called public purpose, and demand that our regulators and supervisors do the job of promoting a safe and sound financial system. It's true that some entrepreneurial folks, like former trader Brad Katsuyama, who is featured in Lewis's book, are working on alternative exchanges that can bypass the HFT network. But bypassing the system is akin to creating a new bypass to a still rotten heart. The truth is that the whole thing should be destroyed.

Finally, high-frequency trading is getting the scrutiny it deserves. The best move is to get rid of it: the SEC should move to end exchange access speeds that one player advantage over anybody else. Of course, given the lack of enthusiasm with which the SEC and other regulatory bodies have approached any kind of reform, banning the practice seems unlikely. At the very least, introducing a financial transaction tax of one basis point on securities transactions would severely dent the profitability of this practice and effectively tax it out of existence. And as former CFTC Commissioner Bart Chilton suggested, fines ought to be levied on those who engage in unethical practices:

“If you’re making millions in seconds, then you should be liable for fines for bad conduct, counted in seconds. I know this is a revolutionary way of thinking about money penalties, but I believe it’s a necessary step to take in order to both deter illegal conduct and assess sufficient penalties to bad actors in our markets.”

Ultimately, high-frequency trading is the symptom of a much broader problem. We have an overly financialized economy, dominated by a few mega-institutions which have corrupted our political system and poisoned our economy. After the Great Depression, the greater involvement of the federal government in the economy through spending, taxing, discounting, and regulation provided a more stable economic and financial environment for the private sector.

Over the past 30 years, the quality of government involvement has declined dramatically and the political system has become a money-for-hire whorehouse. If anything the “reforms” which have been introduced since the Great Financial Recession of 2008 have allowed large financial institutions to consolidate their power as a result of the crisis, largely through government assistance. In this kind of environment, it is unsurprising that high frequency trading has thrived.

We’ve become a society marked by high private indebtedness, an over-reliance on financial markets as a source of income, income inequality and predatory capitalism. As high-frequency trading illustrates, the sooner we downsize the financial sector, the better.