04/08/2014 05:46 pm ET Updated Jun 08, 2014

Institutional Corruption in High Frequency Trading

The number of Americans holding financial stocks has been steadily falling for more than six years. A big portion of this trend can be blamed on the great recession, and what is seen as a suddenly realized peril of even seemingly solid and famous institutions going down as they succumbed to high-risk operations in the market. However, the ordinary U.S. citizen is showing increasing distrust towards the market, seeing it as an intrinsically unfair place, becoming more unfair and less comprehensible with the impact of the fast pace of new technology.

One of the reasons this is happening is that ordinary investors have been pushed out by so-called high frequency trading in the stock market, in which the importance of actual companies' value is not the main driving force encouraging investors to participate in the market in the first place. It is overshadowed by the process of making money on the transactions themselves, and particularly on being the quickest and the deftest in doing so. Around half of all stock trades today are attributed to high frequency trading. This way of trading is often seen as profiting from unfair advantage, sometimes calculated in just fractions of a second, and obtained by advanced technology and sometimes dubious methods, such as using algorithms that signal the high-frequency trader what his slower-paced colleague is trying to do. This information is then used to outpace him. For instance, by buying the same shares, he is trying to buy and thus increasing their price. High-speed traders often even cancel a large share of the vast number of orders they place, trying to find the most advantageous ones.

Being fast is crucial, as signaled by the vast investments in new technologies: Perseus, a HFT company in Europe, spent somewhere between 10 and 20 million euros constructing its network of microwave dishes from London to Frankfurt, increasing their response speed by 40 percent. Sometimes high frequency traders pose themselves close to the stock exchange, using the advantage of information obtained some milliseconds earlier than traders further away, due to their proximity.

Another part of the problem is the stock exchanges themselves: Since they profit from the volume, in competing with each other, they started providing high frequency traders the unfair edge over the "ordinary" investors. This practice also pushed out long-term investors, an important component of the economy and stock trading. Several complaints about stock exchanges' favoring high frequency trading reached the Security and Exchange Commission.

Commodities Futures Trading Commissioner last year called for a special transaction fee on speculative trading that would slow high frequency trades and "make them more thoughtful" about the wave of their orders, sometimes causing misbalance, driving up costs for buyers and generally not improving the market. However, when N.Y. state regulators did that years ago, the fee was abandoned as the exchanges threatened to divert trade to New Jersey. This kind of a fee would make sense only if it is introduced globally and even on the federal level, it would be very hard to regulate and cover possible exemptions and loopholes. Italy, however, launched a levy on HFT last October.

However, it would be quite unfair to display all of high-frequency trading as unfair and mischievous: Some high-frequency trading adds liquidity to the markets that badly need it. In addition to that, the technological edge these traders are using made trading overall cheaper over the years. HFT firms assert that they need the advantages to make up for the risk they take on as they help the markets operate smoothly. Therefore, the remedy to the problem seems to be not to ban or disadvantage high-frequency traders (as it is nearly impossible), but rather to distinguish "harmful" from "positive" counterparts, attracting them to new, special exchange platforms. There, a delay between the orders might be set up, preventing fastest traders to achieve an advantage. However, more importantly, exchanges would not help HFT by charging them lower fees or granting them special order types; same fees for everyone might be enough to discourage predatory HF traders. And, what's most important, it could provide ordinary investors with an opportunity to participate on equal footing in the market.

Developed as part of a Harvard course on Institutional Corruption led by Lawrence Lessig and William E. English (Ethical Reasoning 36).