In recent years, a confluence of factors created a new reality in the world of equity trading. The emergence of ultra sophisticated electronic trading methods, simultaneously with stock exchanges converting to for-profit and the SEC's Regulation NMS, have brought on an explosion in trading volume.
Compounded by flawed regulation and lax oversight, this new marketplace is dominated by tech savvy, secretive, predatory and highly profitable trading programs, exploiting traditional investors who are usually oblivious.
High frequency trading systems are proprietary computer programs whose automated algorithmic software initiates trades with the goal of collecting rebates from the exchanges and/or detecting institutional order flow, and then execute buy/sell orders ahead of that flow.
These programs are designed to automatically front run investors. They have an information advantage, and they unnecessarily increase volatility, cause retail and institutional investors to chase artificial prices, make markets less efficient and systematically transfer wealth away from ordinary investors.
They also have a huge market share, and thus often dominate the market and determine its direction. Their hidden cost adversely impacts the financial well-being of all of us.
The preponderance of high frequency trading programs is not a secret. It has been a rapidly evolving practice in the last few years, and constitutes a major growth industry for financial firms. Yet, despite its devastating effect on investors and the manner in which it impugns the very integrity of our capital markets, the issue receives little attention from regulators.
Some very large and well known Wall Street institutions are involved in this practice. Ever wondered how Goldman Sachs is making so much money so soon after the financial system nearly collapsed? High-frequency trading is one answer: recall that Goldman Sachs recently sued a former employee for allegedly stealing certain trading software Goldman said is responsible for substantial trading profits.
Alleviating these issues requires relatively simple solutions that are easy to implement. For example, the exchange could curb program trading whenever the market moves more than 2%, and require that all orders remain valid for at least a few seconds. It is doubtfully wise for our civilization, in which capital markets are so critical, to tolerate such glaring loopholes and nefarious practices, sundering trust and confidence in the system.
Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com