Why High-Frequency Trading Will Not Become Regulated and Who It Really Impacts

by Robert “R.J.” Raglin

Since the release of the book “Flash Boys” by award-winning author Michael Lewis, much of the news in recent weeks has focused on high-frequency trading and whether or not it should be regulated. In his book, Lewis explains how high-frequency traders have an unfair advantage against all investors which allows them to consistently make successful trades and earn a large profit. There is no single way to describe high-frequency trading, but the most common method involves paying stock exchanges for faster access to information about the flow of orders. Firms then implement this information into complex algorithms to try and predict the direction of the market to buy and sell stocks ahead of investors, thus taking advantage of impending stock prices. The traders with the fastest execution speeds will be more profitable than traders with slower execution speeds. This practice has led Lewis and may investors to call the stock market “rigged”, but is high-frequency trading actually illegal, and who does it really hurt?

This month marks the five year anniversary of the United States (U.S.) Bull Market; however, stock ownership is at a record low and less than half of Americans trust U.S. banks and financial services firms. A large reason for this may be the stigma that people working on Wall Street, such as high-frequency traders, are somehow fixing the market and taking peoples’ money. After the release of “Flash Boys” several investigations have been launched to probe into high-frequency trading and to judge its legality. The FBI, Securities and Exchange Commission, and New York Attorney General are all seeking to discover potential criminal behaviors among these fast traders. The question that we must ask is where these investigations were during the past few decades when front-running has been one of the most lucrative trading methods in the market.

The investigations are focusing on several topics, but primarily securities fraud and insider trading. The issue that the government agencies are facing is that high-frequency trading firms do not fit comfortably into any of the typical securities fraud theories that have been used to pursue misconduct. U.S. Attorney General, Eric Holder, stated in his testimony before the House Appropriations subcommittee, “When one investor has information not available to the rest of the market to trade profitably, that certainly sounds like the type of insider trading”. This is a valid point, but after taking a closer look we see that high-frequency trading firms that are buying information from stock exchanges fall outside of the ban on insider trading as it is currently defined. The foundation of insider trading law is identifying a misuse of confidential information, in other words, the buying or selling of a security by someone who has access to material, nonpublic information about the security. High-frequency trading firms pay the stock exchanges for order information; therefore, no rule is violated when they use what has been legitimately purchased. They get the best prices by having their trades executed first, which makes the transactions by other investors a little less profitable. The Financial Industry Regulatory Authority’s rule No. 5320 prohibits brokers from trading ahead of their clients. But this rule does not apply to high-frequency trading firms that are acting on their own account. As a result of the aforementioned information, it becomes increasingly hard to prove that high-frequency trading is illegal and that it should become regulated.

One of the primary reasons for the investigations launched against high-frequency trading is the belief that it affects all investors negatively. Lewis states in his interview on 60 minutes, “The prey [of high-frequency trading firms] is anybody who is actually an investor in the stock market, anybody who is even speculating about investing in the stock market.” Lewis goes on to state that “anybody” includes hedge fund managers, mutual funds, as well as the guy with his e-trade account. What he is saying here is not particularly true. High-frequency trading increases stock market uncertainty and introduces the risk of unexpected, super-fast changes in prices that were never experienced previously. However, contrary to Lewis’ claim, there are only certain groups of investors who fall victim to this phenomenon. Both professional traders and short-term investors who constantly buy and sell financial securities are at a disadvantage and end up paying a higher price over a limited time for what they buy. Long-term investors on the other hand do not face this problem. High-frequency trading is unlikely to have a long-term negative impact on returns and it may even produce opportunities to buy at temporarily lower prices and sell at inflated prices.

The question of how to deal with high-frequency trading will be continually probed throughout the rest of 2014, especially with the hype surrounding the release of “Flash Boys”. The government agencies investigating it, however, will have a hard time proving that it is illegal and that it negatively impacts all investors. Only time will tell.

Sources:

http://dealbook.nytimes.com/2014/04/07/high-frequency-trading-falls-in-the-cracks-of-criminal-laws/?_php=true&_type=blogs&_r=0

http://www.marketwatch.com/story/how-to-profit-from-high-frequency-trading-2014-04-07

http://www.forbes.com/sites/genemarcial/2014/04/02/high-frequency-trading-mainly-hurts-the-traders-and-short-term-investors/

http://www.cbsnews.com/news/attorney-general-eric-holder-confirms-federal-investigation-into-high-speed-trading/

http://www.cbsnews.com/videos/lewis-investors-big-and-small-are-prey/

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