05/04/2012 08:55 am ET | Updated Jul 04, 2012

Wall Street's Speed Demons: A 10-Point Primer

People who care about helping companies raise capital to innovate and create jobs don't drive our contemporary Wall Street. "High-frequency" traders do.

A decade or so ago, these computer-driven, warp speed traders didn't even exist. Now they make up about 55 percent of all U.S. stock trading and a rising share in derivatives markets. But how they operate -- and how their high-tech plundering is gutting the financial security of the 99 percent -- remains almost totally unknown to average Americans.

So just who are these "high-frequency traders"? And what sort of games are they playing with our economic future? Here are 10 things you should know:

1. To them, "the blink of an eye" is an eternity: It takes you 300-400 milliseconds to blink. Computers can now receive and send trading information in the span of 10 milliseconds. Since that's way faster than even a chess grandmaster's brain can react, mere humans will have a tougher time foreseeing and managing future financial catastrophes.

2. We don't know who they are: There's no public registry of high frequency traders. Thanks to the private research firm the TABB Group, we have this rough sketch: 48 percent is done by a few hundred proprietary trading houses (so called because they trade their own, rather than clients' money); 46 percent by investment banks; and 6 percent by some 10-20 hedge funds.

3. Whoever they are, they don't know what they're buying: They program computers to exploit fleeting, microscopic price discrepancies in stocks on different exchanges. One critic from within the industry has called this the "nanosecond scalping dance." For all they know, they could be buying shares in a company that produces toxic toys. As such high frequency strategies have exploded, investment in small businesses has dramatically declined.

4. Financial ignoramuses encouraged to apply: Many of their employees are mathematicians, physicists, meteorologists, engineers -- people with the technical skills to build bridges or predict cyclones. Instead they are developing algorithms to drive the computers.

5. They run circles around Joe Schmo investor: For years they've been allowed to locate their servers close to market exchanges to gain a speed advantage. The latest in their technological arms race: installation of a $300 million fibre-optic line beneath the Atlantic ocean to cut five milliseconds off the data transmission time between London and New York markets.

6. Their strategies smell like manipulation: High frequency traders are constantly sending and cancelling orders almost simultaneously. The head of U.S. stock trading for "slow" mutual fund seller T. Rowe Price told the Baltimore Sun, "We know that some high-frequency trading strategies have cancellation rates in the 95 percent range. So that means that 95 percent of the time that you say you want to buy 100 shares of IBM, you don't really buy it. And that begs the question: Why have you said you want to buy? Are you trying to influence someone to do something else? And is that manipulative?"

7. They turn pennies into gold: The goal is to pick up pennies on zillions of trades. Thanks to lawsuit documents, we got a glimpse into how those pennies have added up for two of the biggest players: Goldman Sachs netted $300 million in 2009 and Citadel hedge fund made $1 billion in 2008 off high speed strategies. Citadel has claimed to account for as much as 10 percent of global equities trading in a single day.

8. Even the small fries have big political friends: The prop trading houses that make up the largest share of high frequency trading formed their first industry lobby, the Principal Traders Group, in 2010. They list 35 member firms, few of which have more than 200 employees. Nevertheless, when they lobbied the head of the Commodity Futures Trading Commission last fall for financial reform exemptions, they were accompanied by Chicago Mayor Rahm Emanuel, Obama's former chief of staff.

9. They fueled the Flash Crash: The SEC had to spend nearly five months to reconstruct what happened on the afternoon of May 6, 2010, when the Dow suffered its fastest nose-dive ever before rebounding by the end of the day. There's still some disagreement over the initial trigger of the Flash Crash, but the general consensus is that high frequency traders accelerated the freefall by withdrawing from the market in lightning speed.

10. They could cause the next "Big One": CFTC Commissioner Bart Chilton says we got lucky two years ago: "If the Flash Crash had taken place in the morning on May 6th, when E.U. markets were open, it could have instigated a global economic event." An academic report commissioned by the UK government contends that the "true nightmare scenario" would have been if the crash had occurred just before the closing bell. With regulators incapable of explaining the cause, it could have sparked massive sell-offs in Asia and then spread to Europe. Their conclusion: "on the afternoon of May 6, 2010, the world's financial system dodged a bullet."

So what is the government doing to prevent high frequency traders from causing the next meltdown? The SEC says they're conducting a major study that will lead to stronger oversight, but in the two years since the Flash Crash their main action has been to introduce circuit breakers on daily price gyrations. Senator Carl Levin (D-MI) has dismissed these as merely a "Band-Aid." Regulators don't even have the ability to track such trading as it's happening.

One tool the government could use to address concerns about high frequency trading is a financial transactions tax. At even a fraction of a percent on each trade of stocks, derivatives, and other financial instruments, such levies would undercut high frequency trading's narrow profit margins and encourage longer-term productive investment. Thus far, however, the Obama administration has not supported such taxes.

For the foreseeable future, it seems, the speed demons will continue to rule our financial system.