High Frequency Trading: Clear and Present Danger?

By Markets FOXBusiness

Which sounds more risky: driving a race car 200 miles per hour on the Massachusetts Turnpike, or trying to trade stocks from your home computer while competing against high frequency trading (HFT) — the kind of trading performed by sophisticated trading firms every day — which is known to execute trades within one millionth of a second?

Continue Reading Below

Congressman Ed Markey (D-MA) says it's HFT -- and he wants the SEC to slow it down, if not stop it altogether.

While the Massachusetts Turnpike can indeed be scary, drivers still use it (and some even speed). But Markey says HFT is driving investors off the electronic trading highway completely because HFT is eroding confidence in U.S. markets. 

In a recent letter the Congressman sent the SEC Markey wrote, “…sophisticated trading firms can make full use of light speed HFT algorithms, while the ordinary investor day-trading his 401k remains at more terrestrial speeds…There is a real risk that algorithmic trading is making investors hesitant to re-enter the equity markets because they fear that the entire game is rigged.” 

Markey calls HFT a clear and present danger to the stability and safety of U.S. markets and proposes that, “… its use should be curtailed immediately.”  

More On This...

One highly respected trading network operator welcomes the discussion, but calls Markey’s solution Draconian. Liquidnet founder and CEO Seth Merrin is actively engaged in the debate over HFT, and notes the SEC has a mandate to assure safe and orderly markets. 

Continue Reading Below

“It is incredibly important the SEC looks at these things through the eyes of investor confidence,” he said. Liquidnet describes itself as “a global institutional trading network connecting more than 700 of the world’s top asset managers… across five continents and 41 markets.”  

Merrin, however, has never lost sight of the little guy and what he sees worries him. Merrin suspects HFT has rattled investor confidence. “The market has done very well over the last three years but we are still seeing massive outflows up until the first week of this year.”  

Data from Trim Tabs Investment Research appears to support Merrin’s concern. Trim Tabs data show outflows from U.S. equity mutual funds in 2008 hit a record $148 billion; in 2009,  confidence appeared to be stabilizing as outflows from U.S. equity mutual funds totaled just $28 billion.  

But Merrin says the “Flash Crash” in 2010 dealt a blow to investor confidence that has yet to recover. Trim Tabs reports outflows from U.S. equity mutual funds in 2010 hit $81 billion, $132 billion in 2011 and last year totaled $130 billion. 

Trim Tabs COO Minyi Chen says, “High frequency trading undermines investor confidence and they (investors) want other types of investment vehicles that offer higher liquidity than mutual funds -- for example ETFs.”   

That’s one reason Markey believes the SEC could stabilize market volatility tied to HFT by immediately promulgating “rules that restrict or eliminate the practice.” But Merrin says a one-size-fits-all regulatory approach to controlling HFT is neither practical nor likely to achieve the desired effect. 

“Anytime there is a new issue like HFT, if you look at whether it’s good or bad through regulations written 30 years ago, that is not a sufficient filter to determine if that is good or bad for the market,” he says.

Merrin proposes the SEC create "HFT-free zones" to protect retail investors who wish to trade in a separate and slower lane while allowing HFT to continue. Retail investors, he says, should have the option and the opportunity to decide if they want to interact in the HFT zone. 

“There should be an HFT-free trading zone open to every investor and it should be up to the investors, and right now there is no option,” he says.

The SEC hasn’t yet responded to Markey’s letter. Merrin expects regulators worldwide to address HFT this year and investor confidence to continue eroding until the SEC does something. “Nobody is going to go to a casino or any kind of market if they don’t understand the rules,” he said.

What do you think?

Click the button below to comment on this article.