The unaddressed dangers of high-frequency trading

It is all about the speed of light, not the quality of the investment

While it may appear Michael Lewis unearthed an overlooked financial market conspiracy in his new and much talked-about book, “Flash Boys,” it is anything but breaking news for many who have followed the corrosive technological trend of high-frequency trading.

A year after the Wall Street crash of 1987, I talked to the senior staff of then-Sen. Warren Rudman, asking what lawmakers could do to properly regulate the rise of automated trading programs. Rudman’s response to me in January 1989 was not surprising: “I look forward to the Banking Committee’s report on the issue,” Rudman wrote.

What was then known as program trading, or “portfolio insurance,” has now morphed into the Frankenstein’s monster we now know as high-frequency trading, or HTF. Whatever came of the Banking Committee report in the 1980s is unknown to me. What I know for certain is that in spite of much well-intended legislation, little or no substantial regulatory or legislative action regarding the technologies in control of the financial markets has changed.

Investor advocate Joe Saluzzi at Themis Trading and Scott Patterson at Dow Jones have written extensively on the risks of HFT to a relatively narrow audience of financial professionals. I made my own attempt to raise awareness in March 2012 in a posting, “The Velocity of Investing.”

Though we gained traction two years ago, neither Charlie Rose nor “60 Minutes” asked me to be interviewed. What is clear is that Michael Lewis has a better publicist than the rest of us, and for that I am grateful.

Perhaps Lewis is being overly dramatic when he says the markets are “rigged,” but the new attention to this matter is more than welcome.

The human component

If you remember the groundbreaking movie, “2001: A Space Odyssey,” the most important character was HAL, the computer who was amorally programmed to eliminate human folly. When HAL took charge, it was much to the detriment and safety of the humans on the voyage into deep space. An investor today must ask which HAL now controls today’s investment environment.

This is not Luddite commentary. Of course we need technology to handle the massive and sometimes complex daily trading in a global market system. But where is the human component, and why don’t public companies get involved?

A true HAL moment prompted the “Flash Crash” of May 6, 2010. If that event has been forgotten, then shame on all of us. The Dow Jones Industrial Average dropped some 600 points in a few seconds and prices briefly entered an alternative universe that few could comprehend. A number of quality issues saw their shares trade at levels 500 times their prior close while a number of other issues traded in the pennies before the mayhem was over.

It was a powerful lesson on what happens when the human side of order execution is superseded by sophisticated and dark systems that can kick into action automatically on a wide range of fronts.

In Patterson’s “Dark Pools,” computerized “bots” are taking over the trading game and outwitting their human creators. I suspect the market could become even more volatile as exchange-traded funds become more prevalent.

Lewis also shines a light on another dark side of HFT – the now legalized front-running of HFT firms who have a brief head start on trading action because of the speed, capacity and location of their networks. The skimming of trade prices is but a smart, technological advance on the mob raking in their take from Las Vegas casino revenues.

There’s risk-free money to be made when you can buy a stock at one price and then sell it at a higher price in less than the blink of an eye. And while only pennies are made with each transaction, they add up to billions of dollars that are paid by unsuspecting investors for a parasitic service they know nothing about.

Other parts of the world have attempted to mitigate the danger. The European Union has enacted an HFT transaction tax. The network infrastructure of the Hong Kong Exchange doesn’t allow for much HFT manipulation and is considering a market “circuit breaker” to protect against flash trading of stocks.

In a clash of eras, as Lewis’ book was generating controversy and discussion, legendary Wall Street investor William “Billy” Solomon was celebrating his 100th birthday. “A handshake or a thank-you on the telephone was a confirmation of a transaction,” the former head of Salomon Brothers said on Bloomberg. “Today you have lightning-fast trading which no one understands. It’s a vast difference.”

When investments and investors reconnect, HAL and HFT will take a back seat.

Tom Sedoric, managing director-investments of the Sedoric Group of Wells Fargo Advisors in Portsmouth, can be reached at 603-430-8000 or www.thesedoricgroup.com.