The SEC Should Ban High Frequency Trading

The discussion in the past few months regarding “High Frequency Trading” has been deep and persistent, especially given the SEC’s recent initiation of a review of the strategy on Wall Street. This success and importance of this little-known strategy has also been highlighted in recent months by Goldman Sach's $4bn profit in Q2 (driven in part by HFT), as well as the theft of Goldman’s proprietary high frequency trading strategy by a former employee

For those who are unaware of this strategy, high frequency trading is basically an algorithm that allows incredibly fast access to various markets by traders (think millionths of a second). Flash trading also allows a trader to “flash” orders on an exchange for a fraction of a second, oftentimes ahead of other orders in the queue. The issue here is that there are potential abuses that could occur because of this strategy – abuses that can undermine confidence in and stability of the market.

Arguments have been made that you cannot regulate the progress of trading strategies and technologies just because some market participants are superior traders or have better access to technology. I agree that this type of regulation is impractical and goes against free market principles. However, supporting high frequency trading ignores the 2nd (and higher) order effects of this decision, which, net-net, are more important to the overall stability of and confidence in the fairness of the markets than the profits of a select group of trading firms. First off, I should clarify that I do not take issue with the “speed” factor of the algorithms. As almost every exchange has moved away from an "open outcry" trading system towards an electronic system, speed and the cost efficiency of trading have improved several fold in the last few decades, and will most likely continue to do so. Simply put, this is positive for all investors. Nor do I take issue with the “frequency” factor. The frequency of trading is in essence, liquidity, which is positive for both sellers and buyers. What I do take issue with is the fact that these flash orders can potentially allow traders to get a “free look” by trading on different exchanges than they should normally be trading on (should they not have had the possibility to execute flash orders). This type of technology can also potentially be used to manipulate the price of a security in favour of the trader. These factors alone should be enough to convince you that high frequency trading is dangerous.

However, the typical rebuttal from high frequency traders is that anyone with enough capital can purchase the requisite technology and expertise needed to employ this strategy, hence there is no unfair advantage to anyone using it. While this is true, the practical reality is that a very select few trading firms (select hedge funds / prop desks) have the ability to implement and execute high frequency trading strategies. These firms are privileged enough as it is, and do not need the additional advantage of having the ability to front-run their clients or trade ahead of the market, regardless of whether or not they will actually do so. Allowing high frequency trades and flash trades is irresponsible because while it does not promote front-running, it does allow the potential for it. We should protect the markets against any threat of manipulation, because in my experience, any advantages (fair or unfair) will be used on The Street. Unless the SEC can regulate AND effectively enforce any market abuses resulting from high frequency flash trading, it should be banned. History has shown that the SEC has not only been consistently behind the curve in recognizing market abuses (for a recent example, see the SEC announcing a review of Goldman's trading huddle practices literally the day after they were detailed on the front page of the WSJ), but has been almost wholly ineffective at halting various frauds and scams. This is why, in my view, high frequency trading should be curtailed now before it becomes the next big scandal on Wall Street.

Blodget & Spitzer...Round 2

I wanted to post this fantastic interview delivered by Henry Blodget, who sits down with the former New York State Attorney General, Eliot Spitzer, to discuss AIG, the bailouts, compensation, and regulatory roles. I have always maintained that Eliot Spitzer was one of the shrewdest regulators of our time because he almost single-handedly took on Wall Street in reigning in illegal acts by many of the largest investment banks throughout his tenure.

http://www.thedeal.com/dealscape/2009/08/henry_blodget.php

What I find particularly interesting about this interview is Spitzer's clarity on the issues that have plagued Wall Street over the past 2 years. He calls out the government's failed involvement in the bailout of AIG, how regulators have enough power as it is, as well as how regulators and the regulatory system have failed to an extent. His rationale on each of these issues is second to none, and it is a shame that he is not in the same position of power that he once was. If there ever was a time that Main Street needed Eliot Spitzer to protect it from Wall Street, it would be now. While I am generally an advocate of the free market economy, Spitzer's "no-holds-barred" approach to regulation is just the tonic our society needs to better deal with the ongoing corporate malfeasance. As Spitzer himself said, the drive for wealth creation is inherently good for society; however, it is the after effects of that insatiable drive that we must avoid, as it's damage is greater than the benefits of being a purely free market.