Speedy Trading Screws Up The Market

Posted: Feb 12, 2012 12:01 AM

To long time market watchers, the story I linked to in Breakfast Links and am writing about now is no surprise. High Frequency Trading screws up the way markets trade.

A group of professors in Florida have done some research that points directly to the machines causing statistically unnatural drops in equity prices 18,000 times from 2006-2011. I am actually surprised it’s so few with all the ETFs, stocks, options and futures that trade. If there are 220 trading days per year, that’s a possible 1100 days which means 16.36 times per day some tradable instrument has a flash crash.

The quick and dirty solution prescribed by unknowing bureaucrats is a Tobin tax on trading. Tax the trades and then it will stop. Actually, volume will get thinner. Bid/Ask volumes are already thin. A tax will cause more flash crashes because there will be less in the market to stop them. Not to mention the fact that it will increase trading costs tremendously, not from the tax but by the slippage in the market for big orders to initiate positions and exit positions. Risk will be heightened. No, a Tobin tax would be the worst possible solution to the high frequency trading problem.

What needs to happen is a change in the structure of the market place initially. Currently we have a distribution system codified by poor regulatory policies. The distribution system rewards the HFT players, rewards the big banks, and compromises humans, pension funds and point and click traders. As we have seen since the flash crash, the disadvantaged are exiting the market. Volume on regulated exchanges is down($NYX, $NDAQ). Total volume is down. Cash is building up on balance sheets and in bank accounts. Entities distrust the market because they know the game is slanted against them.

How do we change it? Increase the level of competition on the bid/ask spread. End dark pools, end internalization of order flow. Make all orders go to one central limit order book. Trade in .05 increments instead of pennies. Bids and offers would thicken and the machines wouldn’t have as easy a time front running and manipulating markets.

The other thing that you can do is force banks to act as either brokers or traders. If they want to trade their own proprietary accounts, let them-but prohibit them from transacting any customer business. If they want to act as a broker, fine-but then they can’t trade prop accounts. Just like the dual trading rules we had at the CME($CME). Customers felt more confident about the marketplace and volume didn’t suffer after we passed rules against top step trading and dual trading.

The problem is the regulators and Congress is bought and paid for by the distribution system that is favored with the way things currently stand. So it’s not going to change.

Europe will be the first to enact a Tobin tax for trading. The Democrats in Washington will soon be calling on America to follow. They already have introduced and endorsed bills that were killed. It’s the fools way to solve a real problem. It’s also the cowards way out.