Controversy Over High-Frequency Trading Is Hardly New


Like any significant technological innovation, high-frequency stock trading has had a polarizing effect on the industry it has changed forever.

To its advocates high-frequency trading -- the use of sophisticated computers to trade large amounts of stock at extremely high rates of speed -- is a paradigm shifting, revolutionary leap forward. To its detractors it’s an unregulated badlands teeming with outlaws and bandits. The reality, of course, lies somewhere in between.

Peter Nabicht is a former executive at high-frequency trading (HFT) firm Allston Trading who now touts the benefits of the innovation as a senior advisor for an industry group called Modern Markets Initiative.

“People tend to think of (HFT) as a trading strategy. It’s not a trading strategy or a business model. It’s a tool, nothing more than a tool,” said Nabicht. A tool he and other supporters say has dramatically increased liquidity, improved efficiency and lowered costs for all investors.

Dennis Kelleher, chief executive of Better Markets, an advocacy group that supports increased market transparency, strongly disagrees.

“Only people getting paid by high-frequency trading firms talk about the ‘benefits’,” said Kelleher. “There are mountains of evidence that market manipulation and abusive practices are rampant” among the ranks of high-frequency trading firms.

Gaming the System?

In short, critics say that when misused the speedy technology is good for little more than gaming the system.

This debate has been bubbling on Wall Street for more than a decade, ever since computers replaced humans as the preferred method for buying and selling stock. Now, while virtually all stock trades are conducted via computer, more than half of those are bundled into high-frequency transactions.

"I was under the impression stocks were a long-term investment...”

- Wall Street trader

Best-selling author Michael Lewis pushed what was formerly an insular Wall Street debate into the wider public eye earlier this week with the publication of a new book, “Flash Boys: A Wall Street Revolt,” about high-frequency traders. In a provocative interview Sunday on CBS’ “60 Minutes” Lewis said: “The United States stock market, the most iconic market in global capitalism, is rigged.”

Lewis and other HFT critics say the practice is used (or misused) to skim billions of dollars in profits out of the markets that would otherwise go into the retirement accounts of average mom and pop investors.

For example, HFT players use fancy software and complex algorithms to anticipate large moves in certain stocks, usually big purchases by mutual funds. The HFT guys then buy the stock at a lower price ahead of the mutual fund and in a nano-second sell it back to the mutual fund at slightly higher price.

The HFT computers are capable of conducting these types of transactions at a relentless pace and with unprecedented speed.

Hardly a New Controversy

Since most mom and pop investors hold stock through mutual funds managed by their retirement accounts, this continual skimming by high-frequency traders adds up to billions in lost retirement dollars each year, the critics say.

What’s more, many HFT firms get paid by the stock exchanges through rebates to make markets and provide added liquidity, a useful service but one that critics say can be easily manipulated. HFT firms also pay to locate their computer servers within those of the exchanges, which cuts tiny fractions of a second from the time they receive market data, just enough time for their software to rapidly trade on the information.

“This is all just a hidden fee lining the pockets of Wall Street mostly at the expense of retirees who need that money,” said Better Market’s Kelleher.

New York Attorney General Eric Schneiderman has put high-frequency trading in his cross-hairs, recommending reforms that would remove what he has described as “unfair advantages” held by the tech-savvy traders.

And earlier this week the FBI confirmed to The Wall Street Journal that the agency was in the preliminary stages of an investigation to determine whether some tactics used by HFT firms were illegal.

Trading veterans and academics who study Wall Street note that the HFT controversy is hardly new and that much of the current ire targeting the practice likely stems from a general lack of understanding of how stocks are traded.

Robert Jennings, a finance professor at Indiana University’s Kelley School of Business, said small investors who are buying and selling 100 shares at a time likely benefit from high-frequency trading because of the added liquidity and narrow price spreads created by all the HFT market makers competing to complete trades. Mutual fund investors could lose out “over time,” however, because so-called front-running by high-frequency trading programs target those larger transactions and gradually eat away at investors’ profits.

Does HFT hurt small investors?

“It’s a tough question to answer definitively,” said Jennings. “It depends on how you’re trading.”

“Benefiting from the Efficiencies”

“This isn’t a new issue,” added Keith Ross, CEO of PDQ Enterprises and a veteran high-frequency trader.

Ross said there was little public outcry 10 or 20 years ago when traders regularly skimmed the difference between stock price gaps that were much larger than they are today now that stocks are sold in decimals rather than fractions. So instead of raking in the gap between nickel, dime and quarter price spreads, high-frequency traders are skimming from gaps between pennies and fractions of pennies.

An investor who puts $500 into the stock market today will see $497 of that go into their investment, Ross estimated. A decade ago that figure would have been about $480 after commissions and other market-related fees, he said.

In sum, Ross explained, electronic trading and its next evolutionary phase HFT has eliminated (or greatly reduced) the role of expensive middlemen, and the deeper liquidity provided by all that speed and efficiency makes it easier for individual investors to buy and sell stocks at more advantageous prices.

Mom and pop investors “are actually benefiting from the efficiencies of the market and I think that’s a very good result,” said Ross.

Still, one longtime Wall Street trader gave voice to the growing skepticism of HFT flamed by Lewis’ book: “One way or another, flash boys are reaching into the pocket of ma and pa and taking small amounts of money out -- day after day, year after year. So sure there should be concern.”

The trader added, “For me, the most telling statistic is the flash boys’ average holding time of their ‘positions’ -- 11 seconds. I was under the impression stocks were a long-term investment.”