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Archive for the ‘High Frequency Trading’ Category

Yesterday’s Sunday New York Times’ business section featured a lengthy article on the proposed takeover of the New York Stock Exchange by an Atlanta based company with the unfortunate three letter acronym of ICE. Here are parts of this story that caught my attention.

ICE, the IntercontinentalExchange, is located in a modest, nondescript office building in Atlanta. There are not enough employees working there to fill the building – at least two other companies have marquees out front. ICE personnel eat their lunch in the same cafeteria with those other companies’ employees. The small personnel footprint is a direct result of the computer based management of the exchanges that ICE already has. This fact has caused anxiety among the traders on the floor of the NYSE who still handle the orders.

While ICE founder and CEO Jeffrey Sprecher maintains that he knows investors will still want a human being on the other end of the phone overseeing the trading, I doubt that he will need as many such people physically present on the pricey NYSE trading floor as opposed to sitting at computers in Atlanta or anywhere else. In short the computer leverage that is already a powerful force in the trading process is likely to increase.

At the same time, Sprecher recognizes that the flash crashes that occasionally occur with individual stocks and less frequently with an entire market, are not a good thing for the long haul. According to the Times’ story, ICE “has been praised as one of the first exchanges to put limits on lightning-quick, high-frequency trading.” Having that mind-set at the helm should be welcomed by investors, and would lend some hope to addressing the ethical issues of high-frequency trading that we have discussed in a prior post.

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HFT is computer trading. In and out of a position in less than 50 milliseconds. Think it doesn’t affect your portfolio? Think again. Even though a trade may last such a very short time, it can impact your portfolio in two ways.

One impact, though rare thus far, can be quite dramatic. It is the software error that produces a “flash crash.” A flash crash occurs when one computer’s programming mistakenly identifies a sudden drop in a stock’s price or in a broader segment of the market. The computer immediately initiates orders to sell stock and, just like a human based panic, this triggers other programs on other computers to sell as well. Individual investors can be caught in this sharp decline before the bounce back either because they are on line at that time and see it occur or because they have stop loss orders set up on some of their investments. Their stock is sold at a greatly reduced price and the next day or 30 minutes later, prices are back up where they had been.

The second impact is in the overall perceived fairness and reliability of the market. Many recent analyses have been written about the large percentage of potential investors who are on the sidelines because they don’t trust the market. Knowing that flash crashes can now occur, knowing that a large percentage (some estimate as much as 60%) of the average day’s trading volume is initiated by computers, knowing their human stock broker and her firm cannot control this phenomena — all combine to discourage investment. When investment is discouraged, prices are depressed. When investors stay out, they miss potential market upswings.

But the debate I want to participate in is whether or not HFT is ethical. This weekend’s New York Times Business section devoted coverage to two stock brokers, Sal Arnuk and Joseph Saluzzi, who have written a book on HFT and are highly critical of this type of trading. The Times’ article mentions a heated exchange between Mr. Saluzzi and another guest on a CNBC program that resulted when he raised the “ethical” question.

Here is why I believe that the practice is ethically flawed: it violates the ethical standards in two layers of my Seven Layers of Integrity® — the community standards of fair play and moral and spiritual values.

Community Standards

The basic premise behind the market is that stock prices are “free market driven.” Perceived value of a share of stock is determined by supply and demand, by investors bidding for a share but limiting their bid to a particular value. HFT damages the free market for publicly traded stocks by manipulating prices to its advantage within a far shorter interval than humans can react:

  • As noted in the Times article, HFT does not just place trades. HFT is capable of gaining price intelligence, and then acting on that intelligence, in literally less time than you can blink your eye.
  • Programs submit trades, learn that the trade is not accepted, then cancel the trade all within a few milliseconds. The trade is re-opened in a smaller block or at a slightly better price.
  • An investor who sees a posted price on the exchange is not able to get that price as the computer on the other end alters its selling price by a penny, tempting the investor to move up.

None of these activities can be replicated by humans due to the rapid time span (hence, “high frequency”) in which the computers can operate. In short, it is like the IBM chess playing computer versus a human non-expert chess player. And the nature of what takes place alters the market pricing in a way that has nothing to do with the “free market” concept.

HFT eliminates a level playing field on the exchanges for all investors. No one is saying that all investors have equal intelligence, but all investors do have the right to expect their trades to be honored. I have personally seen my own limit orders go unexecuted even though the electronic ticker at my online brokerage service shows that the price dropped to below my limit during that timeframe and a buyer existed.

Moral and Spiritual Values

HFT has a tendency to create and increase instability in the market, thereby impacting the portfolios, savings and net assets of private citizens around the globe, not just the few investors in a particular stock on a particular date.

  • No computer program ever written is flawless.
  • As instability from one piece of software arises, it has a strong tendency, as seen in actual examples, to cause other programs on other computers to react negatively.
  • Crashes can occur at the speed of computer interaction.

As I have commented in other posts concerning the financial industry and its failure to acknowledge culpability in events that impact millions of people, there is no spiritual principle I am aware of that justifies risking the life savings and jobs of ordinary people around the world so that a few firms and their partners can have even more money. HFT has sent a few warning shots across the nation’s economic bow. As long as we allow it we are risking a much deeper impact across a much wider swath of the world’s economy.

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