February 19, 2013

Last week, The Wall Street Journal published an op-ed written by an assistant professor from the University of Alaska titled "Regulator, Go Slow on Reining in High Speed Trading" (registration required). The piece was a warning for regulators not to intervene and try to slow down the high frequency traders.

From the WSJ:

Attempts to regulate the speed or type of information in the market may distort markets. For example, high-speed trading has reduced bid-ask spreads, reducing trading costs for investors while increasing market efficiency...Attempts to regulate the speed of markets may create distortions that reduce the efficiency of markets in our high-velocity information world.

The op-ed was trying to take a free market approach to the problem of high frequency trading:

"New competitors will continue to enter a market until profits approach zero, and that is what appears to be happening in high-speed trading. The increased number of these traders has sped up the velocity of the market for everyone, making it increasingly difficult to take advantage of microsecond gaps in trading."

As Americans, we believe in capitalism and free markets but there are some areas of our economy that need to be regulated. Would you feel safe flying in an airplane if the FAA did not constantly police the airlines? Even professional sports require rules and regulations to keep the games fair and safe. The stock market is another critical area of the economy which requires rules and regulations.

There are some that believe markets are self-correcting and that regulators should follow the "do no harm" approach. We agree that sometimes regulations end up creating more damage than what they were trying to fix (for example, Regulation NMS). But we also believe that if left unchecked, some market participants, namely the for-profit stock exchanges and the high frequency trading community, will put their own short term profit motives ahead of the overall good of the market. Regulators have traditionally relied on the stock exchanges to police the markets but lately stock exchanges have been acting and behaving more like brokers.

[For more on a stock exchange's role in the modern markets, read: Are Exchange System Errors the New Normal in High Speed Markets?.]

Due to the pendulum shift to almost full automation and the massive fragmentation of the stock market over the past decade, our equity market currently lacks a self-policing mechanism. This mechanism existed for years in the stock market and helped protect the integrity of the market while rooting out bad players. Self-policing exists in many aspects of our life. Take professional hockey. Each team has an enforcer. If you take an illegal shot at a team's top player, then expect their enforcer to come after you on your next shift. No illegal shot goes unpunished.

Until the stock market can bring back its enforcers and start to self-police again, it will be up to the regulators to step up their surveillance and enforcement activities.

ABOUT THE AUTHOR
Joseph Saluzzi is partner, co-founder and co-head of equity trading of Themis Trading LLC, a leading independent agency brokerage firm that trades equities for institutional money managers and hedge funds. ...