While still in its early stages, a fight has erupted around the legality of high-speed trading, a lucrative practice key to trading firms and the exchanges that take their well-calculated bets. New York’s Attorney General’s Office, the FBI and the SEC are each investigating high-speed trading. If authorities make the practice – which New York Attorney General Eric T. Schneiderman has dubbed “Insider Trading 2.0” – illegal, there will be significant fallout for market participants, but don’t expect the days of old school trading to come back en vogue.
Illegal or strategic?
If you ask some people – like Liar’s Poker author Michael Lewis, who just penned a well-timed expose on the practice – high-speed trading is a vehicle used to help cheat the system, and not just mom-and-pop retail investors. Mutual funds, hedge funds and broker dealers are affected too. High-frequency trading firms pay exchanges for proprietary data feeds that give them a view of market supply and demand milliseconds before the competition. They use complicated algorithms to jump in front of other orders – hundreds of thousands of times a day – to grind out near a guaranteed profit. One such firm – Virtu Financial – booked a daily loss just once during the last 1,238 trading days. In comparison, Goldman Sachs posted losses on 27 days in 2013 alone.
“In the normal world this is known as front-running and is completely illegal,” said Chris Apostolou, a former economist who’s now the managing director at London-based Arbitrage Search and Selection. “It’s completely wrong in my opinion and only a matter of time before people go to prison for it,” he said.
Exchanges counter that high-speed trading provides much needed liquidity in the market, creating enough buyers and sellers to keep all market participants happy. Either way, authorities appear primed for battle.
If high-speed trading were to be vanquished, “it would obviously create a class of unemployed quants,” said Adam Zoia, CEO of Glocap, a Wall Street search firm. In addition to analysts, ultra-high frequency – aka ‘ultra-low latency’ – traders would be removed from the market, added Apostolou.
However, “they could probably find gainful employment in other areas of the market because of their excellent technical skills, just they’d be trading at a lower frequency,” he said.
As for the old school, non-technical traders, they’re likely to remain on the bench. “In the long-run, most market makers and execution traders are a doomed species,” Apostolou said. Most traders of liquid markets these days have to have C++ skills to get an interview, and many experienced traders have just become compliance oversight for automated trades, he said.
“We certainly won’t be going back to the days of paper-filled stock exchanges,” added Richard Lipstein, managing director at Gilbert Tweed International.
The real victims of a losing battle over high-speed trading, other than the firms themselves, are the exchanges, which many feel are the true instigators of the perceived immorality. You can make the argument that high-speed trading firms are just taking advantage of the opportunity provided by exchanges, which allow them to physically plant their computers in exchange server rooms. The commissions on those hundreds of thousands of trades would be greatly marginalized.
As for the lack of liquidity in the market, that issue is open for debate. Some believe that the lower trading volume would significantly impact the market. Others think that, while market volume would be hugely reduced, you’d just be ridding those that are gaming the system. “It may not make a material difference [on liquidity] when most of the trades were circular,” Apostolou said.