High Frequency Trading – Wall Street’s Latest Darling or Next Regulation Nightmare?

Posted by on June 17th, 2014

Last weekend I was having a conversation with a group of friends regarding Flash Boys, the recent book by former Wall Street traitor trader turned author, Michael Lewis. The book focuses on high-frequency trading which is a type of trading that uses sophisticated computer algorithms and technological tools to rapidly trade securities within nanoseconds. In the book, among other story lines, Lewis describes how trades are being rerouted in an expedited fashion to exchanges outside the NYSE and NASDAQ that result in better prices for clients of high frequency traders (HFT) and screws the less fortunate (the less fortunate being everyone who is not a client of high frequency traders). Brokerage firms have been doing something of this sort for a while as they have diverted trades from the exchanges into “dark pools” within their own firm in which the client hardly gets the best execution price given the non-existent transparency in these pools.

Following these discussions, I immediately thought, “How in the hell is any of this legal?” A friend of mine mentioned that he knows of a hedge fund where one of its algorithms makes 40,000 trades in one hour and looks to make $0.01 on each transaction on any exchange (Pink sheets to NYSE/NASDAQ). And that is just one of their algorithms out of hundreds. How do you think they are able to make that $0.01 on each transaction? Through these high frequency traders that’s how. They are able to place these transactions ahead of others using slower platforms. How, you might ask. It is because within nanoseconds of a slower platform inputting a trade, a high frequency trader is able to come in, see the order flow and basically “front run” on trades. Front running is illegal/unethical trading in a stock where you are buying or selling a security based on knowledge of pending orders. Again, it brings me back to “How in the hell is any of this legal?”

We work with several companies that have requested help in understanding the trading in their stock, who is buying and who is selling. We have subscriptions with several services that help us determine these transactions and who has recently bought and sold securities in these companies. However, with the increase in high frequency trading and volumes shooting up on all of these exchanges, trying to determine who is buying and selling just got a lot more complicated. So let me pose another question, who is getting screwed here? Investors, companies or just about everyone outside of these HFT’s?

Today, the Senate Permanent Subcommittee on Investigations is holding a hearing titled “Conflicts of Interest, Investor Loss of Confidence, and High Speed Trading in U.S. Stock Markets.” Several securities industry professionals are appearing as witnesses, including Flash Boys protagonist Brad Katsuyama, as this panel looks to uncover the potential concerns that having been arising from high frequency trading. With most free market thinkers, government intervention (aka regulations) would be the last thing they are looking for however this is something that I believe needs to be looked into. What types of hazards are out there? Is it possible for another Flash Crash or something worse to happen? Let’s just hope it’s not too late.