Unless We Act, High-Frequency Trading Will Crash the Markets

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High-frequency trading isn't illegal. But the way it is practiced today, it should be.

That's because high-frequency trading, or HFT, doesn't add to market liquidity, stability or efficiency — but it could cause a catastrophic market crash.

Here's what's wrong with allowing high-frequency trading, what HFT practitioners say they're doing that's good for the market (which is rubbish), what could happen based on what has already happened, and what to do to fix this black hole.

The problem is HFT is based on a lie.

High-frequency traders send out tens of millions, if not billions, of orders to exchanges that are never meant to be executed. They are fake orders designed to dump manipulative information onto the nation's exchanges.

And while other market participants are not actually forced to adjust their bids and offers or engage in any of these trades, allowing access to the exchanges to manipulate anybody in any way is something that ought to be outlawed.

Exploiting an Unfair Advantage

In the HFT world it's all about speed. Without it, HFT wouldn't be possible.

There's nothing wrong with employing external innovations that speed up computers or the time it takes for information to get from one server to another. But HFT takes it to an entirely different level.

As I write this, chains of fixed microwave towers are being erected to send market data and orders between New York and Chicago because electromagnetic radiation travels only 2/3 as fast in glass fibers as it does through the air. The towers were designed and are being built by a pair of HFT entrepreneurs who already have HFT customers lined up.

And as soon as this winter passes, Hibernia Atlantic's Project Express will be dropping a more direct new generation transmission cable across the Atlantic so data and trade executions can travel faster between New York and London.

The new cable will reduce the 30 milliseconds travel time it takes now by only a few milliseconds, but space has already been leased to the only takers, the HFT crowd.

It may be unfair that some players are able to pay for a speed advantage by employing new technologies, but it's certainly not illegal.

What should be illegal, and is an abomination, is that the SEC allows exchanges to serve high frequency traders by leasing them co-location space next to the exchange's servers.

Not everyone can afford that access. But because it can be bought, HFT players have a significant speed advantage over everybody else who expects the SEC and the nation's regulated exchanges to guarantee equal access to get data and place trades.

Trust Me, It's Not About Liquidity

The HFT crowd argues that they act as market-makers and add liquidity wherever they practice their trades and both markets and investors are better served by their activity.

That's absolute nonsense.

A market-maker (I was one on the Floor of the CBOE in the 1980s and was an OTC market-maker in several big name stocks in the 1990s) is someone willing with their own money (or firm capital) to either buy or sell shares of a stock and posts a bid and offer all the time. Market makers, like the "specialists" on the NYSE, are charged with "keeping a fair and orderly market" in the stocks they trade.

HFT players are not market-makers at all.

They have no obligation to make a market in any stock. They never have to post a market or ever honor the bids and offers they post. In fact, their game is to post fake bids and offers that they have no intention of honoring.

They are not market-makers at all. They are market-manipulators.

HFT players claim they add liquidity to the markets and point to the high volume of trades they do "as market-makers" as proof. Additionally, they claim that their activity helps narrow spreads, which they claim reduces transaction costs and adds stability.

Sure enough, HFT activity is responsible for at least half of the daily 6.8 billion shares traded across America's exchanges, and as much as 78% by some measures.

But that doesn't mean their activity adds liquidity. It just means it adds to volume.

Any time HFT's share of daily volume is greater than 50%, it means they are trading with themselves. There is no way (at present) for us to know how much activity is between HFT desks when their share of daily volume is 50% or less. How is that added liquidity?

Nanex, a market data provider and research firm, says this about the illusion of tighter spreads and claims of greater market liquidity:

"We have found significant evidence that overall NBBO (national best bid and offer, see my article from yesterday) spreads have not decreased since the implementation of Reg NMS in March 2007. Combing through over 0.7 trillion quote and trade records, we sorted stocks into bins by NBBO spread every second of the trading day. We then plotted the results and were surprised to find no evidence of tighter spreads. What is worse, we found that the NBBO spread has become less stable since 2007. An unstable NBBO is an indication of a drop in liquidity, or that visible liquidity might be an illusion."

Nanex notes that "liquidity might be an illusion" since 2007 parallels the dramatic increase in high frequency trading.

We've already seen what can happen when HFT goes berserk.

The Flash Crash in May 2010 was caused by HFT running amok. The SEC won't admit it because it's too scary for the public to know they aided and abetted HFT, and now can't control it.

How else could the Dow drop 1,000 points in 10 minutes and stocks like Accenture (NYSE: ACN) drop to a penny, and then they all sort-of bounce back?

The truth is that wouldn't be possible if HFT players were market-makers. Where were the bids they were supposed to be posting as market-makers? The only way a stock could drop to a penny a share is if there were no bids. Where were the bids?

Because HFT players pick off other market participants by manipulating them, those other traders, including institutional traders don't put down multiple or large share-order bids anymore.

Because of what has been allowed to happen, liquidity isn't just an illusion, it's non-existent.

As long as markets are functioning normally, the HFT crowd is in there playing. But in any panic situation, they are going to step out and turn off their computers.

What will happen to spreads then? What will become of liquidity?

We already know what will happen. We saw it with the Flash Crash, we saw it with the Facebook IPO, we saw it when it blew up Knight Capital, and we just saw it when it turned on Kraft stock two weeks ago.

Leveling the Playing Field

Allowing high-frequency trading as it is presently practiced will lead to a catastrophic market crash that will not only destroy trillions of dollars of wealth in America and around the world, it will destroy the economy in the process and ensure that a recovery won't be possible because the public won't have any faith in the capital markets that are supposed to be about capital formation, investment opportunity and risk transfer.

The SEC and all exchanges need to immediately end anybody's exchange access speed advantage that in any way disadvantages anybody else.

No one should be allowed to post fake quotes to manipulate other traders or investors.

If HFT players want to become market-makers, make them post their markets, and make them honor them.

If HFT players are so good for the market, let them prove it by making them identify themselves so they can be monitored and by making them leave their quotes out there for a minimum amount of time.

What's wrong with leveling the playing field on some forms of disruptive trading and making the capital markets safer for investors and America's future?

So what if volume dries up? We'll get a slower but more stable trading environment.

That beats a catastrophic market crash.

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. James Mackie | October 16, 2012

    Thanks for your comments on high frequency trading. The problem is this is such a money making activity for the participants that they are able to spend huge amounts on lobbying the regualtors. There are many simple solutions, like requiring orders to be placed for a minimum of a few seconds. It is just difficult to get the regulators to understand how destructive this activity has been to the stock markets. The fear of the markets and the volatility has driven and continues to drive investors into low volatility investments like TBills and short term bonds. This is not productive. It is not helping the economy to recover.

  2. philomena | October 16, 2012

    Shah, I agree with you completely about the high frequency trading practices.

    Unfortunately the only time the SEC will doing something about it is when the 'stuff' hits the fan. Then everyone will say "Shah brought it to our attention years ago".

    This will be the same as the LIBOR rate situation, only the HFT effect will be many times greater and more devastating.

    What and how can small retail market participants do so not to be wiped out when HFT blows up?

    Phil L – West Palm Beach, Fl

  3. William | October 16, 2012

    Mr. Gilani,

    Are you familiar with Avaaz? If so, have you considered aligning with them in some way or another so as to utilize their influence in hopes of reversing or halting practices such as HFT? Apparently, they have been successful in their efforts to do so in the past and have a global reach.

    Just an idea I had while reading your news this morning.

    Regards,

    William

  4. Sailor Jo | October 16, 2012

    Very good article.
    Sad part: If you want to get screwed, leave it to Wall Street. They find a way.

  5. Richard | October 16, 2012

    Good Article…. Many things can be said but it all comes down to one thing….. It is no accident that the wealthiest Counties in the USA are around the District of Columbia.

  6. Caio | October 16, 2012

    That was a very good article, we'll remember it some years from now :)

  7. Myron | October 17, 2012

    How about we all insist on all trades being processed on 1 second intervals in random order received with a max ratio of unfilled orders to filled orders. This gives everyone equal access, and the randomness does not let anyone play the system. It slows sudden movements giving humans a competitive chance against computers. Anyone exceeding the max ratio has their orders moved to the back of the queue during the interval. This exposes them to fulfillment on the next interval before their order can be canceled.

  8. Lenore Borash | October 17, 2012

    10-17-12 Your letter "act now before its too late…" on HFT is very frightening to read. When you say ACT NOW…what do you mean….other than leaving the market? What can we as investors do, if the SEC can't or won't act responsibly. For many years I have felt the market is manipulated in numerous ways, but this extreme current method is terribly firghtening. What do we do….what do you do…..are we to wait for the inevitable to happen, or do we leave the market, and leave the investing to the charlatans…who will eventually destroy the good for the bad??? L. Borash

  9. Inquisitive Thoughtful | December 23, 2012

    The article seems to be VERY biased against HFT. The facts seem mostly accurate but the opinions are SEVERLY negative and misleading; and the tone of the author is quite hostile as well.

    Can the articles can be written, with a notch down on the aggressiveness and bias factor?

    About the regulations bit, we need to remind ourselves of the changing times and the technological gear shifts that are currently taking place in every industry. The smart thing to do now will be to learn, adapt and grow towards a more developed future, because any resistance to change will only hurt us; it's inevitable.

    Reminds me of the Bob Dylan song: "The Times They Are a-Changing"

  10. Matthew | January 20, 2013

    The orders aren't fake. The computer just decides that the algorithm dictates something else. But,I do agree that canceling orders should be regulated.

  11. Chris Vermeulen | May 8, 2014

    I'm not sure that anything should be done about high frequency trading. Trying to impose restrictions like that only serve to distort the market. It's true that we're seeing increased volatility in the markets, thanks in no small part to algorithmic trading solutions, but this is part of what the “new normal” looks like. I don't see it as an inherent good or bad, just the new topography.

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