I Was Wrong.

You do not hear many investors saying this statement. In fact, you almost never hear investors saying this statement because it is simply a matter of psychology. Any active investor, myself included, is by definition stating that they are smarter than the person on the other side of the trade. This is clearly not always the case, which is why it is imperative that you learn early on in your investing career when to be persistent in remaining in / increasing a trade and when to pull out. Humility. Understanding and embracing that one word will go a long way in ensuring that you make the right trades for your portfolio. The truth is that the market will humble you at some point in time. The question is whether or not you listen to what it is saying, and more importantly, if you learn from that particular mistake. The greatest investors will admit they were wrong, and then will proceed to pull apart their own mistakes and the mistakes of others in trying to improve their investment process. This is what differentiates the good investor from the average. The good investor focuses on their process of investing, whereas the average investor focuses on the outcomes.

While I have made numerous mistakes in my investment portfolio, one of the ones that I have made on this blog is an entry I wrote in August 2009 entitled "The SEC Should Ban High Frequency Trading". In a very uncharacteristic moment of irrationality, I wrote the blog arguing that the SEC should be more responsible and should disallow HFT. I was wrong. Upon further thought and discussion, it is my contention that the SEC is not well equipped to deal with traders who are have more resources than and are faster and smarter than the market regulator itself. Banning HFT outright is a poor policy response to a natural evolution in the free markets. To disallow progress is to disrupt the very foundation upon which our capitalist system is built. Case in point, the Globe & Mail ran an article today about a new trading system named "Thor" that RBC Capital Markets has been developing for its buy-side clients. This product is designed to deliver much-needed relief to fundamental long-term investors who are getting out-gunned in the markets on a daily basis due to the natural advantages that high frequency trading systems have accorded to the quants and hedgies. This system is basically an evolutionary response by the markets to negate the abilities of HFT, and it appears to work successfully (for now). We do not need more regulation. Like animals in the wild, the markets have evolved and adapted to the hunting strategies of high frequency traders. Economics tells us that abnormal profits will eventually be eroded away through competition. The development of RBC's system is just the first step in the evolution of competition when it comes to HFT. My initial position was wrong. I believe in free markets.

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.

Thoughts on the SEC's short sale actions

Short selling has been on the receiving end of public scrutiny and outrage for the past few quarters, as many believe hedge funds are to blame for the financial crisis. While hedge funds may have added fuel to the fire, their use of short selling did not cause the problems we are experiencing today. In my view, short selling is extremely useful because it allows market participants more ways to express their views on the value of a security, and thereby profit. It also acts as a counter-balance against the undue optimism sometimes present in a security, and can bring that security's price back to reality.

Whether you are for or against short selling, I think all of us can agree that the SEC's monitoring and regulation of short selling, and in particular naked short selling, has been poor at best. Just to clarify, naked short selling is the act of short selling when you do not have the "borrow" available. It is a particularly pernicious activity because it can allow someone to manipulate the market for a security.

Yesterday, the SEC announced several measures designed to better regulate and disclose the act of short selling (http://www.sec.gov/news/press/2009/2009-172.htm).

The measures are three-fold:

1. Brokers must purchase or borrow securities to deliver on a short sale. While this rule was already in place, it is being made permanent in order to curtail naked short sales.
   
2. A plan for SRO's to publicly disclose price and volume information regarding short sales. They are also continuing to review proposals on short sale price tests and circuit breakers for individual stocks.
   
3. A roundtable will be held on September 30th to discuss new measures including "securities lending, pre-borrowing, possible additional short sale disclosures, the potential impact of a program requiring short sellers to pre-borrow their securities, possibly on a pilot basis, and adding a short sale indicator to the tapes to which transactions are reported for exchange-listed securities".
   

I believe these measures are extremely positive for the market. I do applaud the SEC's efforts in (hopefully) regulating short sales the way they should be regulated, and increasing short sale transparency through more public disclosure. The only real negative to come from all of this is that all of this new regulation requires resources - resources that could be put to better use. In particular, it will increase the costs involved for short sellers - most likely legal and compliance.