High-Frequency Trading: Beneficial but Probably Illegal

High-Frequency Trading: Beneficial but Probably Illegal

After an extensive review of high-frequency trading, Michael Lewis claims in his book “Flash Boys” that stock markets are rigged.  Many are therefore asking whether the average retail investor, already gun-shy from the financial crisis, should simply stay away from the stock market.  High-frequency traders claim that they have helped the small investor by improving liquidity and reducing transactions costs dramatically.  Critics say that high-speed traders are front-running the average investor.  Both claims are correct.   

High-frequency traders have replaced market makers who used to populate the floor of the New York Stock Exchange.  Market makers paid millions for a seat which was basically a ticket to riches, allowing them to skim a quarter of a point per trade off millions of trades that took place under their watch.  Back in those days, executions were slow, spreads were high, and commissions per trade were hundreds of dollars.  In contrast, today trades can be carried out in milliseconds with ample liquidity and miniscule spreads for commissions less than $10 per trade.  We have high-frequency traders to thank for many of these changes.

However, high-frequency traders did not improve the creaky markets of yore out of the goodness of their hearts.  Like most good capitalists, they sought to make a profit from market inefficiencies.  Specifically, they profited by arbitraging price discrepancies arising from the time lags inherent in the old system compared with the new.   Unfortunately, time is a key element in the definition of insider trading.  Becoming privy to material information not yet available to the general public and then acting on that information to make money is against the law. 

While it is true that HFT arbitraging has narrowed dollar spreads to pennies and days-long delays to microseconds, the amounts are still material and the information they trade on is still non-public.  Acting on such information is the definition of insider trading.  Ironically, therefore, high-frequency traders have benefitted small investors by dramatically reducing the cost of trading over the past decades, but they are still stealing pennies from you on your trades. 

One solution that has been proposed is to penalize canceled orders. While this would disincentivize front running, it does not address the root of the insider trading issue which is the time differential.  The only way I can think of to address this issue is to slow everyone down to a least common denominator as Brad Katsuyama has implemented at his IEX exchange.

 SEC April 3, 2014

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