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Time for a Speed Limit on Wall Street: Slowing Down High Frequency Trading

It appears that the German Bundestag is ready to impose meaningful limits on high-frequency trading, or ”HFT.”

This is a very big deal.

High-frequency trading is an extraordinarily dangerous practice that has fundamentally changed capital markets in the U.S. and around the world, and not for the better. The U.S. regulators seem to have recognized the problem, but have been so cowed by the threats of budget cuts and judicial review of their rules by the right-wing D.C. Circuit Court of Appeals that they have taken to dithering in the matter of the public’s interests.

HFT employs complex algorithms to drive supercomputers tied into trading venues, such as exchanges. The algorithms are intended to react to events transpiring in the markets and implement trading strategies to profit from anomalies. The systems act at dizzying speeds measured in nanoseconds (that’s one-billionth of a second).

The strategies embedded in the algorithms have virtually nothing to do with the objective value of stocks, bonds or derivatives. Factors such as earnings reports, crop yields and Fed actions are irrelevant at these speeds. They are designed to exploit transient events that happen each and every day. Defenders of HFT say that this is a good thing. It efficiently squeezes out distortions in the markets, making prices reflect fundamental value.

If this were the whole story, HFT would be a benign force. It is not.

Recall the “Flash Crash” in May 2010. As it turns out, I was on a Stairmaster watching CNBC as the crash occurred and was resolved before my exercise session was over. The Dow Jones Average plunged over 1000 points in a matter of minutes. This represented approximately $1 trillion of market value. A large and inadvertent mutual fund order sparked the event.

The error was so obvious that even the CNBC commentators immediately concluded that a mistake had occurred. But the HFT algorithms were not so judicious in their assessment of the situation. HFT traders exited the market at blazing speed, dumping vast amounts of stocks on the way out and driving the market off a cliff. As luck would have it, this occurred in the middle of the afternoon (ok, I was in the gym playing hooky from work). Had the market not had time to recover, an international panic may well have ensued. The CFTC’s chief economist concluded that HFT acted as an accelerant, turning a house fire into a firestorm.

This is not an isolated incident. Mini-flash crashes occur daily in the markets, demonstrating repeatedly the hubris of the Wall Street wizards in trying to reduce the collective actions of millions of market participants into an equation.

The problems reach far beyond hubris. HFT traders are not satisfied with passively watching for anomalies. They aggressively create and exploit them. For instance they use pattern recognition software to locate large investors relatively insensitive to price (“pinging” for “whales”). When a whale is located, they spring a trap by cornering a small slice of the market. The HFT trader then implements “quote stuffing,” a tactic designed to flood the exchange with orders, soon to be canceled, to deny access to other traders that could disrupt the whale operation.

This all sounds like a video game played by quantitatively gifted adults acting like adolescents. Why is it so important? The facts are simply staggering. Here are just a few.

  • Studies have estimated that as much as 73% of all trading volume is the result of algorithmic HFT.
  • At the end of World War II, the average holding period for a share of stock was 4 years. In 2000, it was 8 months. By 2008, the average holding period declined to 2 months. And by 2011, it had declined to 22 seconds. If short-termism is an American disease, HFT is certainly one cause.
  • Quote stuffing is pervasive, happening several hundred times a day. It has been found to adversely affect the prices of 74% of U.S. listed equities. This means that HFT gaming goes on all the time.

The markets are now unreliable. Retail investors have fled even today’s bull markets. And institutional investors have opted for shadowy “Dark Pools,” venues in which they can buy and sell beyond detection by HFT. (HFT has infected Dark Pools, by the way.)

Perhaps the U.S. regulators will take courage from their international counterparts. It's time for a new speed limit on Wall Street.