In August 2009, then Senator Ted Kaufman wrote SEC Chairman Mary Schapiro to urge her to study quickly how dramatic changes in our stock markets had in only a few years time led to an explosive growth in computerized trading. THE PAYOFF: Why Wall Street Always Wins, written by Jeff Connaughton (Kaufman's chief of staff), tells how the letter triggered an "air wing" of Wall Street executives to fly to Washington and lobby Congress and the SEC.
Ted's letter to Chairman Schapiro helped draw the media's attention to dark pools and HFT, which began to receive extensive (and concerned) coverage in the financial press. The letter also transformed Ted from a virtually unknown Senate newcomer into a brightly flashing blip on Wall Street's radar screen. In response, Wall Street scrambled an entire air wing of bankers and lobbyists to buzz Capitol Hill. Soon, squadrons were swooping into our office, anxious to thwart new regu- lations following the financial crisis and, particularly, to prevent a crackdown on HFT. They were numerous (we typically met with five high-level Wall Street executives at a time) and unanimous. Whether a megabank, broker-dealer, or a hedge fund, they all said they believed that the stock market had never functioned better. "Competition has driven down the costs of trading," said one. "The spread between a stock's asking price and offer price has never been so narrow," said another. "There's always enough liquidity -- even during times of market stress -- to ensure that trades will almost certainly be executed," said a third. The refrain "mom-and-pop investors have never had it so good" was intoned by nearly all of them. As a former lobbyist, I almost had to admire the way they unswervingly stayed on message. And the message was that the status quo was good for everyone and that Ted and I were wasting our time exploring whether market changes might call for statutory and regulatory changes.
It would've been easy, and quite understandable, for us to be convinced by Wall Street's unanimous message. But we'd been educating ourselves about these issues and we were convinced that there were, to use Donald Rumsfeld's locution, too many unknown unknowns for us to stop burrowing for answers and prodding the SEC. Our chief burrower was Josh Gold- stein, a twenty-two-year-old college graduate who'd deferred entry to Yale Law School for a year to come work for Ted. Josh is brainy, curious, and tireless. He spent all day, every day, immersing himself in the arcana of HFT, stock market structure, and regulation. He soon became so knowledgeable that his questions in meetings would elicit who-the-hell-is-this-kid looks from Wall Street lobbyists. We also had help from a few industry insiders (who worked with us on the condition that we never mention their names publicly), which suggested there was less unanimity than Wall Street wanted us to believe.
We learned about a range of trading strategies, some of which are beneficial to the average investor, but some of which are predatory and harmful. One HFT strategy is called pinging. It involves attempting to "uncover how much an investor is willing to pay -- or sell for -- by sending out a stream of probing quotes that are swiftly cancelled until they elicit a response. The traders then buy or short the targeted stock ahead of the investor, offering it to them a fraction of a sec- ond later for a tidy profit" (the Economist). Another HFT strategy is called quote-stuffing. It involves purposefully sending millions of orders to one trading venue to slow it down imperceptibly so that the trader can take advantage of time and price disparities at other trading venues. There are also momentum strategies (in which traders take a position in a stock and then use HFT to generate market momentum that would benefit their position) and liquidity-detection strategies (in which traders use HFT to front-run -- that is, buy or sell microseconds ahead of -- incoming orders from pension and mutual funds). An SEC staffer stated that in some instances these strategies "could be manipulation" and "would concern us."
The Tabb Group estimated in 2009 that HFT generates $8 billion in profits annually. The question is: How much of this profit is from legitimate practices that benefits all investors, and how much of it is effectively an illicit toll extorted from average investors without their knowledge?
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