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

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 boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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