High-frequency trading: Market manipulation or fair game?

By SAMANTHA HENRY, The Daily Transcript Wednesday, July 24, 2013 Some investors are paying to receive trading information seconds before the public does. Known as "high-frequency traders," these investors use sophisticated technology and algorithms to buy millions of shares at once -- without studying the companies they are investing in or the long-term effects of what they are buying. The practice has recently generated controversy among the financial industry. Those against the pratice of high-frequency trading (HFT) say it is not good for the market and want it to stop. We asked two local experts to share their thoughts on high-frequency trading, and if they think it should be banned. Reed Bermingham Financial Advisor Manning Wealth Management From the obvious inequity to the broader long-term effects, I can think of a few reasons why I believe that high-frequency trading should be banned, or at the very least taxed in a manner which would limit the incentive to partake in such front-running and market manipulation. It is computerized front-running, and front-running is illegal: It is illegal for stockbrokers to front-run a clients order (as it should be), but not illegal for a HFT firm to front-run the entire market population. Front-running amounts to a stockbroker putting in a personal trade in advance of a trade requested by a client in the same security. The broker does this knowing that the clients order will increase the market price and allow the broker to sell the shares they just purchased at the higher price created by the clients order. When a HFT firm executes a flash trade, they are able to do the exact same thing. Flash trading is a common HFT strategy, in which a trader or firm pays to see incoming orders seconds before the order is sent to the entire market system. This not only allows HFTs to gauge market sentiment before it becomes reality, but manipulate prices by entering massive orders in advance of the forthcoming orders to squeak out profits of pennies per share, which adds up quickly when millions of shares are traded. It creates newsworthy volatility that can mislead investors: The action of HFT firms in advance or in the wake of market making news (Fed statements, jobs reports, etc.) can send markets plummeting when this news is less than positive. What results is a flurry of news reports along the lines of Bad Jobs Data Sends Market Reeling, which can be misleading. Often times, what actually sent the market reeling was the action of high-frequency traders looking to profit on an impending market move in either direction. This news then gets consumed by long-term investors who confuse daily market action with long-term fundamentals. This can lead to a ripple effect of poor investing decisions, as long-term investors unnecessarily question their investing tenets based on the actions and market impact of day traders. At its worst, the volatility created by HFT can spiral out of control as seen in the Flash Crash of 2010, causing massive disruption to asset prices with no regard to the underlying fundamentals. Assets relied upon for long-term wealth generation should not be susceptible to this kind of digitally generated volatility. It breeds continued distrust in the financial system: Wall Street and the markets are relied upon by generations of investors to build wealth and secure a comfortable retirement, yet at the same time maintain a reputation of selfserving greed in the eyes of Main Street. The fact that trading firms and institutional investors can legally pay to obtain news seconds before the public and trade on this news, does not do much to help the disconnect and distrust that the average investor already feels towards Wall Street.

Dr. Jaemin Kim Associate Professor of Finance San Diego State University There are actually several issues involved in this question. First, if someone is getting certain information before the general public, then there are apparent legal implications, whether that person is a high-frequency trader or a longterm trader. To the extent that the information is material and nonpublic at the moment, the involved parties, high-frequency traders or not, are subject to insider trading regulations. I am not sure how many seconds we are talking about here. No matter what, several seconds can be a long time in todays stock market. The second issue, an issue different from the first one, is whether or not high-frequency traders increase market volatility, thus destabilizing the market. Quite a few people seem to believe that these high-frequency traders, or day traders, exacerbate market fluctuation and decrease market quality, especially in the down market. However, I do not see any theoretical base for it, nor do I find sufficient empirical support for it. Liquidity or "depth" is an essential element of good market quality, and trading volume is an important measure of liquidity. High-frequency trades add to trading volume. In fact, if there are more of them in the market, trading volume will be larger and thus other things being equal, liquidity will be higher in the market. A deep, liquid market is like the Pacific Ocean -- one person cannot do much to the waves and fluctuations of the ocean, but that person can definitely make a big splash in a small pond, creating significant ripple effects. We want our financial markets to be like the Pacific Ocean. One might argue that these high-frequency traders could make the stock market go down quickly by selling stocks quickly, as seen in the 2010 Flash Crash. Well, if their sell decisions are good ones, i.e. if their algorithms are good ones, then stock prices should fall promptly. In this case, the transactions by these traders are contributing to market efficiency, or the speed with which the market incorporates relevant information. The algorithm issue is the third issue. The algorithm mentioned in the question loosely refers to a computer-based algorithm that includes not only buy-sell decisions, but also buy-sell order executions. Be it a computer-based system or ones knowledge, analytic skill or gut feeling, one will make a killing in the stock market if the algorithm is good. If not, one will lose money. Algorithm trading in and of itself is not inherently good or bad. What matters is whether or not the algorithm is a good one. JP Morgan, a prestigious bank, would like to claim that it has good algorithms. Obviously, the algorithms didnt work well when the bank incurred a loss of several billion dollars last year in the wellpublicized London Whale scandal. I think the key question here is about the second issue regarding market quality. Contrary to some popular views, high-frequency traders -- often algorithm based -- contribute to market quality in terms of market liquidity and informational efficiency. Thus, they should not be banned.