High Frequency Trading Fees-The Wrong Approach

• Posted by Jeff Carter
• on February 23rd, 2012

The SEC is considering ways to curb the effect of high frequency trading on the marketplace. For long time traders, it’s clear that HFT and algo trading have a huge marginal effect on trading. However, they don’t have a macro effect when it comes to price. To clarify, HFT really screws up the moment by moment price movement in stocks and futures. However, when it comes to a settlement price over the long term, all information known about that underlying is priced in. The Efficient Market Hypothesis rules over longer term pricing.

In the old days of face to face trading, none of the shenanigans the HFT guys pull would be tolerated. Eventually, peer pressure would work to force the person pulling those “tricks” to be forced out of the pit or crowd. If they were persistent in their deception, pit committee members would actually write out a violation notice and they would have to appear before a committee of their peers. If the transgression was bad enough, they would be fined heavily, and banned from even coming on the trading floor. Some were even banned from entering orders in any fashion into the marketplace.

Today there is no way to police the bad actors. Quote stuffing, phantom orders and other attempts to manipulate markets are done electronically. There is no way the marketplace can know who is doing it and when.

The SEC solution is to tax the bad actors.

From today’s Wall Street Journal article on the problem,

The Securities and Exchange Commission is looking to curb high-frequency traders’ huge influence on stock trading and is considering charging fees for the myriad buy and sell orders that are later canceled, among other options.

SEC Chairman Mary Schapiro said a large portion of equities trading has little to do with “the fundamentals of the company that’s being traded.” She said it had more to do with “the minuscule aberrational price move” that computer-assisted traders with direct connections to the exchange can “jump on” in fractions of a second.

Such activity “worries me,” Ms. Schapiro said in a breakfast meeting Wednesday with reporters. One solution would be forcing high-frequency traders to pay for the canceled trades that make up nine-tenths of all orders, she said.

Taxing or fining doesn’t provide enough deterrent. This also presumes that the SEC has the electronic firepower to keep up and consistently police the traders that engage in nefarious market compromising activity. The way the SEC is approaching it, innocent traders could be lumped in with the bad ones, and they will have unintended consequences. A fine or tax doesn’t help to restore confidence in the public marketplace either. Currently, there is little faith with the general public that the marketplace is run fairly. Some of that stems from the public perception of banking in general, but a lot of it comes from the fact that when Main Street enters an order to trade they are screwed. The SEC is framing the problem from a policing attitude rather than one that takes into account confidence and competitiveness in the marketplace.

What they should do change some of the practices that lead to market fragmentation. Why not end payment for order flow? If I were a local and an order filler offered me the chance to pay for order flow and get first look at everything in the market before anyone else I’d jump at the chance. How could I lose? Why not end internalization of order flow? If I could pay for orders, trade against them when they benefitted me and if they didn’t, either resell or spit the order out to another place, I’d do it in a New York minute because it bends the risk/reward ratio for trading in my favor. Why are orders allowed to be executed across an ever expanding array of dark pools? If I could run my own exchange for my own benefit and grab orders to instantaneously arbitrage them against another market place for profit, why wouldn’t I do that?

The problem won’t be solved by fining and taxing. It can be solved by changing regulation to ensure that the marketplace is a lot more competitive and transparent. Until the SEC decides to move in that direction, we will continue to lose confidence in the public marketplace. That has long term consequences when it comes to GDP growth, earnings growth, unemployment, and standards of living.

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UPDATE

I was on CNBC with Rick Santelli today. Here is the video. Too bad the bald guy stuttered so much.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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