High frequency trading is gaining significant media attention recently as Michael Lewis published his book, Flash Boys: A Wall Street Revolt, on the subject. While high frequency trading (HFT) was introduced into the markets in 1999, this platform for conducting rapid electronic trades of securities has been gaining significant attention by federal regulators including the Securities and Exchange Commission (“SEC”), the Commodity Futures Trading Commission (“CFTC”), and most recently, the Senate.
Unlike normal long-term trading, HFT entails the use of high-powered computers that use algorithms to trade many securities very quickly. Mr. Lewis raises several concerns about HFT including the bold statement that the “stock market is rigged” as a result of the presence and continued unregulated existence of HFTs. His concerns aim primarily at fairness and transparency with the use and speed of information flows in the market, and the public discussion surrounding the issue has caught the attention of Congress.
Concerns
First, Mr. Lewis explains that HFT gives HFT firms an unfair advantage over other traders because of the time advantage in receiving information about a buyer or seller’s demand for a specific stock. This would give “professional investors an edge over retail investors.” His concern lies primarily with the fact that only HFT firms benefit from this information; however, his concern examines the issue from one perspective—he only discusses the adverse effects of high frequency trading. He fails to consider the myriad benefits that come out of HFT. High frequency trading helps investors cut trading costs, and it further speeds up the rate at which trades occur, which results in greater efficiency in the market. Since this is a relatively new phenomenon that is generating concern in financial and regulatory circles, the CFTC, DOJ and the FBI are all conducting investigations into high frequency trading on Wall Street.
Second, he argues that HFT is seen to crush investor confidence in the fairness of the markets because no human being can make so many trades in the fraction of a second like a computer. As a result, this puts retail investors who do not engage in HFTs at a disadvantage. However, while this may be true, forcing HFT firms to stop using computer platforms to make rapid trades seems out of place given the current technological landscape. Technological development is constantly enhancing the ability of computers to perform rapid trades, and the standard electronic trades on Wall Street has cemented its place in the markets.
Benefits
Despite the problems that Mr. Lewis explains, HFT allows for greater efficiency in the markets by “reduc[ing] the speed of trading and . . . increase[ing] trading volume[].”The overall benefits of HFT include “greater market efficiency in the shape of enhanced liquidity and keener prices.” These advantages have a net positive benefit to the market as a whole and the competition that is generated by HFT allows for greater innovation and efficiency by competing firms.
Potential Regulations
Mr. Lewis’ main concern regarding HFT stems from the lack of any statute to allow regulatory agencies to oversee and regulate high frequency trades. He, along with leaders in Congress, suggest that the SEC, CFTC and/or the Department of Justice should oversee HFT and set guidelines for how it can be conducted. While no country currently has any regulations on the books for how HFT can be transacted on the capital markets, Italy recently implemented a tax of 0.02% on all high frequency trades that last “less than half a second.” While this is one proposal for how HFT can be regulated through the form of a tax, regulators in the U.S. have the means to control and regulate the trades through the SEC, CFTC and the DOJ.
The SEC is currently considering various proposals for how it could to regulate HFT. Mary Schapiro, Chairman of the SEC, has stated that her agency is considering “fees on high volumes of order cancellations or a minimum time enforced for quotes,” but it is difficult to predict which type of regulation will be most effective. Taxing the trades or implementing some sort of fee, while advantageous for generating revenue for the federal government, may not actually lead to greater fairness and transparency in the markets. Since Mr. Lewis is primarily concerned with the issue of timing and access to information, the minimum time enforcement for quotes seems to best address his concerns.
Ultimately, Mr. Lewis raises genuine concerns about fairness and trust in the markets while HFTs go unregulated, but the advantages of market efficiency and liquidity serve as counterpoints to his concerns. One can only speculate as to how Congress, the SEC, and other regulatory bodies will attempt to address the issue of regulating high frequency trades.