Are Average Investors Getting Bilked by Wall Street Supercomputers?

While high-frequency trading has propped up volume in the market, the method rewards shortsighted investors looking to make a quick profit

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As long as there has been a Wall Street, there have been those seeking to skim a little (or a lot) off the top of the vast wealth changing hands in the markets each day. Though capital markets in America are by and large very successful at efficiently allocating resources from investors to deserving businesses, wherever there is great wealth, corrupt forces will seek to exploit it. For example, in the 1990s the Nasdaq stock exchange was embroiled in a price-fixing scandal in which securities dealers were found to be colluding to keep bid-ask spreads — or the difference between the prices at which a stock is bought and sold — high in order to bolster profits.

Partially in response to scandals of that nature, the stock market — with the blessing of federal regulators — has radically evolved. Once dominated by large not-for-profit exchanges like the New York Stock Exchange and Nasdaq, America’s capital markets have, over the past decade, become highly decentralized. The majority of trading takes place in a series of for-profit, electronic venues that compete fiercely to facilitate trades and increase profits. This fragmentation was accompanied and encouraged by the rise of high-frequency trading, a term that describes the use of high-powered computer programs to make hundreds or thousands of trades per minute in an attempt to exploit miniscule inefficiencies in the markets.

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One way high-frequency traders like to make money is by watching large institutional investors — the sort that manage money for your 401(k) or public pension funds — and attempting to predict how they will go about making investments. For instance, a computer program might try to interpret moves in the market to see whether a large fund is in the process of buying up a large position in a stock, and then jumping in ahead of those trades before selling for a profit moments later.

I’ve written previously about how some critics of high-frequency trading are worried that its dominance of Wall Street poses systemic dangers to the nation’s financial system. But there are those who also believe that such practices as described above are actually just a sophisticated way for traders to use high-powered computer programs to extract wealth from the stock market without adding value to it in any way.

Joe Saluzzi and Sal Arnuk, co-founders of the brokerage firm Themis Trading, have been vocal critics of high-frequency trading for several years. In June they published the book Broken Markets, which characterizes high-frequency trading as just another way to soak America’s capital markets.

Arnuk and Saluzzi argue that the evolution of exchanges from not-for-profit “quasi utilities” to for-profit businesses has distorted incentives so that exchanges are now beholden to high-frequency traders, who make up a large share of their business. They write:

Sadly, today, the primary purpose of the stock market is not capital formation. Investors are an afterthought. The primary purpose of the stock exchanges has devolved to catering to a class of highly profitable market participants called high-frequency traders or HFTs, who are interested only in hypershort-term trading, investors be damned. The stock exchanges give these HFTs perks and advantages to help them be as profitable as possible, even if doing so adversely affects you, the investors, because HFTs are exchanges’ biggest customers.

These supercomputers are the source of so much business for stock exchanges that they will sell or give away a lot of data about who is trading what stocks and when. The exchanges also make money by allowing trading firms to “co-locate” their computers at the same facilities where exchanges maintain their computers so that high-speed traders can get information about trades milliseconds sooner.

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Advocates of high-speed trading argue that these computers are doing the valuable service of increasing the total number of trades occurring in the market at any given time, or what those on Wall Street call volume. The idea is that the more volume and liquidity there is in the market, the more accurately prices will reflect the value of a given security, and the cheaper it is for investors to transact. This is broadly true. Volume over the past 20 years has increased in the marketplace, and it is cheaper than ever to conduct trades.

But as we saw in the 2010 flash crash, liquidity can vanish quickly when high-frequency trading programs sniff a bit of trouble. And while bid-ask spreads have narrowed, high-frequency trading is wildly profitable. That profit has to come from somewhere, and since many of these firms are short-term traders, they’re not making their money by doing the hard work of deciding which companies are deserving of capital and which aren’t and sticking with those worthwhile companies as they grow.

They are making their money by taking advantage of inefficiencies in the market — and as Arnuk and Saluzzi would argue — through unfair advantages given to them by exchanges. Those profits are coming directly out of the pockets of long-term investors. If transaction costs have been reduced by additional volume from high-frequency traders, and these same systems are making investing more costly for investors in other ways, how does that enhance the markets? Add to that the volatility high-frequency trading has injected into the system, and the idea that these practices need to be reined in becomes much more appealing.

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