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Risk Management

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HFT: Makings of an Evil Empire

Wall Street's reputation may be damaged, but don't blame all of the industry's woes on high-frequency trading.

Perhaps we can blame the public's negative view of high finance all on Wall Street, the movie. Wall Street is an easy target, especially after the financial crisis of 2008. For most people, it equates to greed and overconsumption and nothing more. In extreme cases, anyone who works on Wall Street is viewed as someone who sucks the life out of honest working folks on Main Street.

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I haven't seen any polls on this, but I imagine that Wall Street's popularity is on par with, if not slightly worse than, views on Congress. That's how bad things are for Wall Street. Now it turns out that there are worse things in high finance than Wall Street itself: We have identified a purely evil force known as high-frequency trading.

In Star Wars, it was pretty easy to identify evil in Darth Vader. Gordon Gekko in Wall Street certainly looked the part of the unscrupulous global financier. Unfortunately, when it comes to HFT, it's difficult to nail down exactly what is evil. I've met with many so-called "high-frequency traders," and trust me, most don't look anything like anyone on Wall Street. In fact, one of them reminded me of my middle school math tutor.

High-frequency trading isn't done by a homogeneous group of firms that engage in specific trading activities with a particular agenda. Lack of a coherent identity among these firms makes it easier for opponents to label them as bad for the market and harder for those engaged in high-frequency trading to respond in a coordinated way.

There have been many academic studies on high-frequency trading in the last few years. Some of them show that HFT is good for the market, while others say it's harming investors. I'm not smart enough to figure out exactly which camp wins this data-driven discourse, but I've been around this industry long enough to realize that it's possible to use the same data set to support polar-opposite views.

For HFT opponents, firms in this category are evil, they're making gobs of money unfairly and they'll ultimately destroy the foundation of the capital markets. The leaders at these firms are way smarter than everyone else and have spent mind-numbing amounts of money on technology to create an unfair advantage over the rest of the marketplace. The only way we can stop them is to come up with onerous regulations to curtail their high-frequency ways.

Process Of Elimination

I'm not going waste my time trying to come up with different definitions of HFT other than to state that in my opinion, HFT isn't a type of firm but a mode of trading. What I would like to do, however, is to point out a few things that I've seen in the last four years that clearly have nothing to do with HFT. This approach is like the process-of-elimination methodology that students use to take the SATs. They might not know the answer, but at least they can get rid of the obviously wrong ones and then have a better chance of picking the correct one. So here's a list of items that aren't related to high-frequency trading:

— HFT didn't cause the global financial crisis in 2008.

— It doesn't hate regulations; in fact, one can reasonably argue that only within a proven and stable regulatory framework (Reg NMS) could HFT even exist.

— HFT isn't flash orders or dark pools.

— It wasn't the main cause of the flash crash; that can be blamed on market fragmentation and electronic trading in general (which would include HFT).

— Bear Stearns, J.P. Morgan, Lehman Brothers, Bernard Madoff, Stanford Financial Group, MF Global, Knight Capital, Societe Generale and the like aren't HFT firms (though most of the banks mentioned here have or have had HFT units within their trading operations).

— HFT didn't cause global warming.

Sang Lee is a co-founder and managing partner of Aite Group. His expertise lies in the securities and investments vertical, and he has advised many global financial institutions, software and hardware vendors, and professional services firms in sell-side and buy-side ... View Full Bio

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