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Sorry, SEC. Fast trading on Wall Street is here to stay

February 28, 2012: 10:15 AM ET

Instead of making an enemy of the high frequency trading firms, the SEC might be better off teaming up with them to help police the markets and provide liquidity.

By Cyrus Sanati, contributor

mary_schapiro

Mary Schapiro

FORTUNE -- The rise of the machines on Wall Street seems unstoppable. While regulators say they are concerned about possible market distortions brought about by computerized high frequency trading algorithms, they don't seem to have any idea what to do about it. In fact, they can't even say with any certainty if their concerns are real or just the stuff of science-fiction.

Nevertheless, Mary Schapiro, the head of SEC, told reporters last week that the agency was mulling ways to curb high frequency trading, namely by slapping a fee on the thousands of canceled orders HFT traders push on the markets. But while such a fee would decrease the chances HFT firms could manipulate the markets, it also would hurt market liquidity, potentially making it more expensive for everyone to trade. Instead of making an enemy of the HFT firms, the SEC might be better off teaming up with them to help police the markets and provide liquidity.

High frequency trading -- computer driven trading executed at super fast speeds -- is nothing new. It has been around for years and has been adopted by almost all the major broker dealers on Wall Street. But after the May 2010 flash crash, HFT was put under a microscope by regulators. At issue was whether HFT algorithms contributed to the super fast 9% drop in market value.

Nearly two years after the flash crash, regulators have done little to curb HFT growth. While they have talked about doing something about it, they just can't seem to nail down the evidence necessary to link HFT to any malfeasance. A massive report on the roots of the flash crash issued by the SEC and the CFTC revealed that there was both human and computer error to blame for the incident and that HFT couldn't definitively be identified as causing any harm to the markets.

Critics maintain that HFT programs are nothing more than a guise for front running and market manipulation. By being able to execute trades faster than the next guy (or computer), an HFT trading algorithm could potentially see bids and offers come in and could hit them off before anyone else had the chance to even blink.

The 15 to 20-strong HFT players on the Street are locked in a computerized war game to build the fastest and baddest trading algorithms. The banks, brokers and hedge funds that make up the HFT community are fighting for slivers of pennies and are willing to get dirty to do it. For example, they normally pay big money to place their trading servers next to the stock exchange servers in an effort to shave nanoseconds of trade executions. Such an advantage is being studied by the SEC, but they haven't made a ruling as to whether or not the "co-location" of servers is truly an unfair advantage.

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Another, more controversial, HFT strategy is to flood the market with a bunch of bids and offers in order to establish where the market is in a given stock. Proponents say this strategy, pejoratively known as quote stuffing, creates a lot of market liquidity given the large numbers of bids and offers that hit the market. Critics argue that it is nothing more than price fishing and market manipulation. They believe that the HFT algorithms are designed to flush out an investor's maximum bid in order to pocket the largest spread possible in any given transaction.

The SEC is having a hard time figuring out who's right here. Schapiro acknowledged last week that HFT does bring valuable liquidity to the markets by compressing spreads, making the market more efficient and cheaper to trade. But she also said that after several years of investigation that she was unsure as to weather or not HFT proposed any harm to the markets.

Schapiro did, however, mention that the agency was considering ways to curb the growth of algorithmic trading by placing a fee on canceled orders. Such a fee would drastically reduce the number of bids and offers high frequency traders send out. That would eliminate the possibility that they could be manipulating the market for their own gain, but it also would strike at the heart of one of HFT's major mandates, which is to provide liquidity.

While market manipulation is very serious, there doesn't seem to be much evidence, so far, to suggest that is what is going on here. HFT, whether critics like it or not, looks like it is here to stay. It makes up some 50% to 60% of the trading volume on exchanges and is expected to grow in the coming years.

So instead of fighting the rise of the machines, the SEC could have an opportunity to use them to help police the markets and maintain liquidity. They can do this by enlisting them to work with the exchanges to become the 21st century equivalent of a specialist. The specialist role largely went away with the rise of electronic trading in the early part of the decade. They acted as a custodian of certain stocks by making sure there was proper liquidity available to it at any given time. In essence, specialists were basically market makers with a true obligation to make sure that trading never fell off a cliff. In return, the specialists are allowed to basically make a good amount of money trading the spread on the stocks they covered.

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HFT firms claim that they are important to the markets because they are the new market makers in stocks, many acting as Designated Market Makers, the successor to the Specialist. But where were the HFT firms that were acting as DMM's during the flash crash? That very fundamental question has been asked time and again, even by Schapiro on several occasions. While some HFT firms claim they traded the whole day, the vast majority backed out of the market when things got tough.

For HFT firms to be a true force for good in the markets, their role as market makers should be made official. The mechanics of such a shift would need to be worked out by the SEC, the exchanges and all the big HFT firms, but it would require coverage of a large majority of stocks, not just the biggest and most liquid of stocks. Forcing HFT firms to provide liquidity to smaller, more illiquid, names would help to stabilize the whole market.

The changeover would ultimately require all the big HFT firms to register with the SEC and to agree to have their trades scrutinized. While that might make some HFT firms feel uncomfortable, it seems a better alternative than having the SEC come in and pull the plugs on their machines.

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