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Ominous Rumblings on Stock Exchanges

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Just because a volcano is dormant doesn't mean it won't erupt again. Sit on top of it, and even minor tremors are a disturbing reminder that the potential for disaster is very real.

That's how I felt when I read about the recent computer glitch that temporarily shut down our third largest stock exchange, BATS Global Markets. Trading of Apple shares was suspended for five minutes, and BATS' own shares fell to a fraction of a cent.

Over the past year, the New York Times reported, there have been at least 110 such tremors that blocked trading in one or more of the nation's 13 stock exchanges. Although the 1,000-point Flash Crash of May 6, 2010 briefly got their attention, most Wall Street traders moved on quickly and now say these incidents are no cause for concern.

I couldn't disagree more. I believe these incidents are proof that there is something radically wrong with our financial markets. If we are going to prevent a disastrous eruption, we had better find out why the tremors persist and what we can do to stop them.

No one disputes the fact that our markets have undergone massive changes. For most of our history, the buying and selling of stocks took place on the floor of a stock exchange during a set time for each session. In the late 1980s markets began to move to electronic trading, although most trading still took place of the floors of the New York and American Stock exchanges.

Electronic trading really took off in 2000, when the Securities Exchange Commission ruled that stock prices would no longer be measured in fractions but in decimals. Because prices could then be digitalized, computers soon took over. Stock exchange floors moved into cyberspace and stocks could be traded anywhere and at any time.

Trading is now being conducted on over 50 different exchanges and in "dark pools" -- markets where institutional traders can make often-huge trades that are concealed from the public. The competition for business among all of these markets has led to a race to the bottom, where rules are stretched to the limit to attract volume players.

The second massive change brought on by digitalization is the use of what is known as High Frequency Trading. In the past 10 years, there has been a computer arms race within the trading community, where faster and faster computers have made it possible to make thousands of trades in less than a second. HFT has grown every year and now accounts for over 60 percent of daily stock trading volume. Remember the quaint old days when we believed in long-term investing?

Traders using HFT have created complex computer programs called algorithms that use historical data to determine the movements in the markets to make a profit. When you make thousands of trades in less than a second, a very small profit on each trade can add up to a lot of money. The Tabb Group, which specializes in research on capital markets, estimates that HFT trading generates $8 billion a year in profits.

What's the problem with this? Start with the fact that no one knows what effect HFT has on markets and the average investor. To get that information, federal regulators would have to put together a "consolidated audit trail" to analyze the impact of HFT on the markets and those participating in the markets. The HFT firms insist they are providing liquidity that facilitates low price trading. I have said repeatedly, without any meaningful rebuttal from anyone on Wall Street, that liquidity in markets is important, but not as important as transparency and fairness.

Without transparency, these markets cannot be regulated. Do we need any better example of the danger of no regulation than the recent financial meltdown? Mary Schapiro, Chair of the Securities Exchange Commission, and Gary Gensler, Chair of the Commodity Futures Trading Commission, have both pointed out the dangers of not being able to monitor their markets, but little has been done to reduce those dangers.

There is some good news. Daniel Hawke, chief of the SEC enforcement's market abuse unit, said "exchange conduct and compliance is an area of renewed enforcement interest." But we know that many on Wall Street will continue to resist changes in a system that produces enormous profits for them. But all of our financial futures are dependent on that system. We must insist on more transparency and a return to markets that are fair to all investors. The tremors keep happening. We can't afford to wait until after the next catastrophic eruption.

Ted Kaufman is a former U.S. Senator from Delaware. Please visit www.tedkaufman.com for more information. This piece first appeared in the Wilmington News Journal.