Everybody Loses

The conventional argument against high speed trading is that it gives an advantage to those with faster technology, not better judgment. It’s unfair. It’s analogous to insider trading, using information not generally available – in this case, milliseconds before it is available to others.

In Flash Boys, Michael Lewis, describes the ingenious technology and shows how it skims profits off the trades of others, working in effect as a tax on the system. He calls it “legalized theft.”

But in his review of Lewis’s book, James Surowiecki noted an even more insideous problem: to sniff out market prices in the process of trying to beat them, high speed traders flood the market with fake orders. They are looking to cheat the market, but, worse, they actually distort the market with spurious activity.

Surowiecki notes “Most high-frequency traders aren’t interested in the real economy at all. They aren’t concerned about a company’s earnings, or its future prospects. The only information that they’re interested in, and that they devote so much energy and money to uncovering, is information about what other investors are going to do.” In that way, they represent the vanguard of investor capitalism, in which the goal of investment is entirely to profit from trading, without regard to its social purpose or value.

He notes that high speed trading now accounts for about half of all stock market activity, and adds: “one recent study of trades in 120 randomly selected Nasdaq stocks found that increased high-frequency trading cost the average institutional investor as much as $10,000 a day.”

Trading in stocks has come a long way from the informal deals made under the buttonwood tree on Wall Street two hundred years ago. It quickly became centralized and regulated – but now it is going in the other direction. Public exchanges are proliferating and globalizing — there are 13 in the U.S. now — competing with each other for bigger shares of the market in markets. Moreover, there are over 40 private markets, “dark pools,” making regulation virtually impossible. Computers and electronic communication have amplified and globalized the process, increasing the chance of manipulation.

The relationships between buyers and sellers are increasingly irrelevant. As Surowiecki noted: “trading is entirely automated—humans may come up with the algorithms that the computers use, but machines do all the trading.” As a result, new glitches occur, such as the “flash crash” of May 6, 2010, when the Dow plunged more than six hundred points in a matter of minutes, and many high-frequency firms just stopped trading. That, in turn, accelerated the decline and made it harder for prices to return to normal.

There has always been a powerful destructive side to capitalism. As productivity soared and new wealth was created, environments were polluted and workers impoverished. This, though, may be different in that the financial system itself is being polluted.

High speed trading with its exclusive focus on maximizing investment returns may make it harden to direct capital where it is most needed or would be socially productive. And it may end up driving all but those who can afford it out of financial markets, as people conclude there is no point in trying to compete with complex algorithms and powerful computers.

In the long run, Surowiecki concludes: “Making investing less valuable will make people less willing to invest.”