Commentary: How High Frequency Trading Benefits All Investors
Traders Magazine Online News, March 17, 2010
Winston Churchill once famously commented that his critics reminded him of a story about a sailor who jumped into a dockside bay to rescue a small boy from drowning. About a week later this sailor was accosted by a woman who asked, "Are you the man who picked my son out of the water the other night?" The sailor replied modestly that he was. "Ah," said the woman, "you are the man I am looking for. Where is his cap?"
Like the boy's mother failing to appreciate the actions of the sailor, the critics of high frequency trading fail to appreciate the major contribution that traders employing high frequency strategies have made towards ensuring that our nation's equity markets the world's most fair, transparent, resilient and lowest cost.
Specifically, a chorus of critics have recently begun asserting that so-called "high frequency" traders, which now make up approximately 60 percent of trading volumes in the United States equities markets and provide critical liquidity to all investors, are harming the market with unfair, speculative trading that causes stock prices to needlessly fluctuate to the detriment of investors.
Variations of this concern have been raised by some very educated and well-intentioned market observers, causing the Securities Exchange Commission and some Congressional staff to begin a more thorough examination that could lead to actions designed to reduce, eliminate or inhibit the use of high frequency trading strategies.
Ironically, acting on the critics' concerns and inhibiting high frequency trading would actually create the type of market reactions that the critics profess to be concerned about, causing considerable economic harm to individual investors, large institutions and, ultimately, to our nation's economy.
To understand high frequency trading and the criticisms of it, it is first useful to review some recent equity market history. In 1996, the Justice Department found that 24 major Nasdaq market makers engaged in "an industry-wide practice that fixe[d] transaction costs" and "anti-competitive conduct which resulted in higher trading costs for individual investors and institutions who bought or sold stocks."
Similarly, in 2003 the Securities and Exchange Commission reached a settlement with five New York Stock Exchange specialists for violating federal securities laws and exchange rules by executing orders for their own dealer accounts ahead of executable public customer orders.
Even CALPERS, the largest public pension plan, filed suit against the specialists for employing "artifices to defraud" and arguing "that NYSE orders were not filled at the best available prices" and, instead, were executed in a way that "financially advantaged" the specialists. In the wake of these scandals, the SEC adopted regulations that fostered competition with the traditional market makers and specialists which had dominated Wall Street for generations.