The High Speed Chase

by Brian Endo ’16

The Commodity Futures Trading Commission (CFTC), Securities and Exchange Commission (SEC), and other regulatory agencies have begun to crack down on the high-speed trading firms that have been reaping major profits in the NYSE, NASDAQ, and future-exchanges like CME Group and IntercontinentalExchange Group. These computerized, high-frequency firms have been able to take advantage of trading discounts due to the large quantities of trade they conduct per transaction. In addition, the firms are able to manipulate the market and control the liquidity of exchanges due to their immediate reactions to the market.

These firms race through the traffic of the normal traders and produce instantaneous reactions to the market based on their algorithmic computer programs. These computers are so efficient that firms like Virtu Financial have amazing trading records consisting of only one trading day loss in a 1,238 trading day span. These trading machines have generated such a competitive advantage that regulators have touted their activity as “insider trading 2.0” and have called for stronger regulations to even the playing field.

The transaction advantages of these firms are rooted from the compiling discounts that the high-frequency trading firms get as they buy larger chunks of contracts. In a sense, the exchanges are promoting the activity of these firms by providing these incentives and allowing the trading firms to place their trading machines closer to the exchanges in order to give them a few millisecond head-start compared to the competition. The quick transactions have allowed firms to take advantage of the volatility within the futures market and capitalize on the high returns available.

The exchanges benefit by these high-frequency firms in a number of facets. The increased activity generated from these firms allows the exchanges to accumulate more money from the firms. Although the exchanges offer discounts, the increased competition by these trading firms would dramatically increase the volume of trades and thus raise the revenue of the trading exchanges. In addition, the firms would compete to place their computers closer to the exchange that creates a bidding war for spots and thus provides another income source.

A major problem with these computerized firms is that they are prone to algorithmic errors that can wreak havoc on the market. The Dow Jones Industrial Average experienced a Flash Crash on May 6, 2010 where the index dropped about 1000 points or 9% during the day, but then recovered these losses within twenty minutes. This instance illustrates the potential danger of these firms  and how their large share within the market can create catastrophic consequences to the country.

In order to limit these firm’s unfair advantages, the regulatory agencies should consider a financial transactions tax (FTT). The FTT is just a few basis points tax that is collected by clearinghouses in financial transactions. France, Singapore, and Hong Kong have implemented a form of the tax making this a viable option. The FTT can cut through the thin profit margins of these firms and definitely even the playing field for a the traditional investor. The FTT will not only weaken the hold of these high frequency firms, but also create large sums of government revenue.

In the United States the FTT, also known as the Robin Hood tax, has faced much scrutiny due to the strong lobbying efforts of the Wall Street firms. The tax will benefit the market by reducing the volatility of the quick transactions, cutting down on large stack derivative bets, and preventing micro crashes.

http://dealbook.nytimes.com/2014/03/18/schneiderman-announces-inquiry-into-services-for-high-speed-traders/

http://online.wsj.com/news/articles/SB10001424052702303287804579447610625554506?mod=ITP_pageone_0&mg=reno64-wsj

http://www.slate.com/articles/news_and_politics/explainer/2011/02/how_does_a_stock_exchange_make_money.html

http://www.forbes.com/sites/leesheppard/2012/10/16/a-tax-to-kill-high-frequency-trading/

 

 

 

 

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