Unbridled High Speed Trading Can Topple Economy

What is more worrisome: the “flash crash” that sent the stock market tumbling more than 9 percent last May 6 within minutes, or that our regulators still don’t know precisely what happened? Although an analysis by The Wall Street Journal laid out the hour-by-hour market convolutions of that day, the underlying cause remains uncertain, as does the SEC’s ability to prevent a recurrence.

For sure, combing through the millions of trades that occurred after 2:30 p.m. of that day cannot be easy. Still, preventing what the SEC describes as an “unprecedented” collapse in share prices might reassure investors that our regulators know what they are doing. Especially since those same regulators are Team One in carrying out many aspects of the vast new financial reform bill.

As important, reining in unfair trading practices that may have contributed to the market swoon would be proof positive that the government was willing to depart from “populist” regulation. It’s easy to clamp down on credit card companies; we all carry credit cards and we uniformly dislike their unforgiving billing methods. It’s another thing altogether to face off against powerful hedge funds and Wall Street firms over trading developments that few people understand or care about. 

New (and Risky) Trading Practices
The extreme volatility of May 6 revealed new trading practices that had been largely invisible to the public. The migration to computerized trading — generally considered a positive development in promoting faster and cheaper executions — has been underway for years. However, the emergence of off-market venues, known as dark pools, the proliferation of high frequency trading, the demise of the human role in market trading, and the use of “quote-stuffing”, naked access and flash trading to gain competitive advantage are relatively new. The potential harm that these approaches could inflict on our markets — and our economy — is unclear; the flash crash made the threat all too real. 

Most of us struggle to even understand these developing market shifts. A shocking report published early this year by the Aite Group in Boston suggested that “naked access” trading –done anonymously through a broker’s accounts so as to elude scrutiny —accounts for some 38 percent of all dealing. Equally surprising is the revelation that high frequency trading, where trades are executed in 250 to 350 microseconds, now makes up some 30% of overall volume. Microseconds are one millionth of a second. That makes those “tenth-of-a-second” victories in the men’s downhill look like landslides.

Quote-stuffing, the newest villain in the dock, involves traders placing and then almost immediately canceling large numbers of orders in hopes of clogging market arteries and gaining an advantage over others. Mary Schapiro, chairman of the Securities and Exchange Commission, has said that many high frequency traders cancel as many as 90 percent of their orders.

The SEC: Playing Catch Up
The SEC has admitted being behind the eight ball in spotting and supervising these trends. In May, Schapiro testified before the Senate Committee on Banking, Housing and Urban Affairs and said, “The technologies for market oversight and surveillance have not kept pace with the technology and trading patterns of the … securities markets.” Think Wyatt Earp galloping across the plains in hot pursuit of Billy the Kid, who disappears over the horizon in a Lamborghini.

Schapiro is now on the case, and announced to the Economic Club this week in New York that the SEC is considering new rules on high frequency traders. Specifically, the SEC will look at what responsibility such traders have for stabilizing markets. On May 6, the abrupt withdrawal of these participants drained liquidity from the market, exacerbating volatility. To combat quote-stuffing, Schapiro is looking at rules requiring orders to stand for a minimum of time. Already the SEC has imposed circuit breakers on the markets, and they are also considering a new tracking system that would provide greater access to information behind the trades, as well as a substantially better “audit trail.”

Will these measures help? It is too soon to tell. Wall Street will no doubt squawk about any new curbs. Wiser heads should not resist rules that will ultimately boost investor confidence. Our markets have been viewed as the gold standard worldwide; people need to think that the playing field — if not level — is at least not mined. 

It all seems a far cry from the age-old practice of investing in companies that have decent growth prospects and whose stocks appear undervalued. That kind of thinking seems as antiquated as the specialists on the floor of the New York Stock Exchange. Still, it was those market makers who stepped in on May 6 and helped restore order. According to one NYSE Euronext spokesman, when the market went off the rails, “it helped to have a human assessing the situation, deciding if the prices are real, and trying to find the other side of a trade.” How reassuring for us humans.