The Ethics of High-Frequency Stock Trading

In the world of business or finance every enterprise seeks a competitive edge to use against its rivals in the quest for profits.

Though not all competitive advantages are legal. A hedge fund portfolio manager, for example, profitably trading equities on insider knowledge, has broken the law; insider knowledge used for stock trading is a competitive advantage, but it's illegal.

What if that same hedge fund trader uses a computer for trading that is smarter and spectacularly faster than others? Computers with these capabilities can automatically execute lightning fast and profitable stock trades in a process called high-frequency trading (HFT).

Individual investors or institutions without access to the expensive, super fast computers are at a serious disadvantage when they trade stocks.

Mid-size and small hedge funds and their traders, financial institutions, brokerage firms and other investors and speculators without access to the expensive, super fast computers are at a serious disadvantage when they trade shares on a stock exchange in which high-frequency trading is regularly conducted.

High-frequency stock trading gives the trader an advantage, knowing the miniscule difference or spread between bid and ask prices. The trades are automatically executed in massive amounts by computer in a mili-second when a stock can be bought for perhaps one cent less than a buy price bid, and then resold for as little as a penny-per-share profit.

Although a mere penny may be involved, the profits can be immense. When trades are made all day, all week throughout the year, the profits add up.

The high-speed computers use algorithms to make the automatic trades. An algorithm is a set of instructions programmed into a computer that makes the computer perform certain actions when specific predetermined circumstances occur.

The computer monitors various stock markets and when a disparity or spread in the bid-ask price of a stock is "seen," the computer instantly executes a trade, buying the stock at the low price and selling it at the high price. The trade is executed at nearly the speed of light, far faster than a mere human being on could do it on the trading floor of an exchange.

According to estimates, the trading volume on U.S exchanges executed by high-frequency computers range from 50 percent to 73 percent. Market research firm, IBIS World, estimated that the high-frequency trading industry is a $29 billion enterprise.

Major stock exchanges, such as the New York Stock Exchange, Nasdaq and BATS, on which high-frequency trading takes place, are among the influential proponents of the practice

High-frequency trading is not illegal, but is it ethical? There are persuasive arguments on both sides of this issue, recently brought to widespread public knowledge by Michael Lewis’s book, Flash Boys – A Wall Street Revolt, and a U.S. Senate hearing on the issue.

Opponents of high-frequency trading, including Lewis, claim that it puts smaller investors at a major disadvantage. Recognizing that the market is rigged against them, the smaller investor loses trust in the market.

Thus, trading volume on exchanges may decline and cause price volatility to increase and liquidity to decrease. Stocks that frequently bounce up and down in price are difficult to sell and their value cannot be accurately determined.

In Lewis’s Flash Boys, he claims the HFT process is rigged against smaller investors and has a negative influence on markets.

According to Lewis and other market experts, high-frequency trading is similar to a stock trading procedure called "front running," which is prohibited by the Securities and Exchange Commission.

Front running is defined as entering into an equity trade with advance knowledge of a block transaction that will influence the price of the underlying security to capitalize on the trade. Traders are prohibited to act on nonpublic information to trade ahead of customers lacking that knowledge. The definition of front running closely parallels the definition of insider trading.

Another area in which detractors of high-frequency trading say it's used to the alleged disadvantage of retail investors are so-called "dark pools."

Dark pools are trading venues in which stocks are bought and sold off the traditional exchanges through high-frequency computers, concealing the trades of participants from the public. Trading anonymously, without the obligation to report trades publicly, gives such traders a major advantage.

Large volume traders who trade anonymously do not have to worry about smaller traders buying the same stocks and therefore driving up the price.

Among large companies allegedly using or having used dark pools according to published reports (MoneyMorning.com and others) are The Goldman Sachs Group, Morgan Stanley and the U.K's Barclays bank.

Recently, the attorney general (of New York filed a lawsuit against Barclays, alleging that the company lied about how high-frequency traders were given preferential treatment in the company’s trading unit. The SEC is currently conducting an investigation of dark pools, to determine if institutions that use them treat all investors fairly and accurately disclose details of their operations.

Although there is no conclusive proof, some market experts suspect high-frequency trading is the reason for the temporary Dow Jones industrial average nosedive of 600 points on May 6, 2010. Dubbed "the flash crash," the sudden drastic decline in the Dow was short-lived and the market returned to its pre-crash levels minutes after it fell.

Advocates of high frequency trading say it provides the necessary liquidity essential to the efficient and reliable functioning of stock markets. Without assured liquidity – the ability of traders and investors to sell their holdings to buyers – markets lose credibility and trading volume declines.

With effortless liquidity and market efficiency, trading costs decrease, say HFT proponents. HFT also narrows the spread between bid and ask prices, and may also reduce trading costs and the impact on share prices that occur when buy or sell orders of large blocks of stock are divided into smaller trades thereby avoiding large movements of a share price either up or down caused by large volume trades.

Statistical data shows that HFT produces profitable trades, perhaps the strongest argument in its favor, at least from the perspective of those who profit from it.

The Senate's Permanent Subcommittee on Investigations recently held hearings on high-frequency trading and its possible conflicts of interest in U.S. stock markets, and its effect on investors loss of confidence.

Among those giving testimony were officials of stock exchanges, brokerage firms, stock market experts and institutional investors. After hearing witnesses, the Senate will determine if drafting regulations and or legislation limiting or regulating its use, imposing regulations or making it illegal may be necessary. And so once more Wall Street practices come under government scrutiny in what seems like the unending conflict between them.