New York Attorney General Eric Schneiderman has set himself the noble goal of making financial markets safer for the small investor. Unfortunately, his latest foray into the world of high-frequency trading will achieve little or nothing toward that end.
Schneiderman announced this week that he is scrutinizing what has become a common practice: Some traders get privileged access to market data by paying to place their computer systems inside exchanges' premises or by subscribing to faster and more detailed data feeds. Because this allows them to act on information that others don't have, Schneiderman sees it as akin to insider trading.
To put Schneiderman's view in the proper context, it helps to understand a bit about how high-speed trading works. Consider two securities, both of which are supposed to track the S&P 500 stock index. From one second to the next, their prices move in lockstep. At shorter time intervals, measured in the thousandths of a second, incoming orders might push up the price of one before the other has time to catch up. This creates an opportunity: By selling at the higher price and buying at the lower price, a trader can make a quick profit.
Such opportunities -- and other, less-perfect arbitrages -- are estimated to be worth billions of dollars a year, but only to those fast enough to seize them. Hence, high-speed traders are willing to spend a lot on being the first to know when an opportunity appears, and to get their orders to the front of the line. Much of that money goes into computer systems, software and ultrafast data links, such as a microwave link that can carry data from New York to Chicago in a matter of several milliseconds. Some also goes to pay for the proprietary data feeds and privileged server parking that trouble Schneiderman. (Bloomberg LP, the parent of Bloomberg News, provides its clients with access to some proprietary exchange feeds.)
The high-speed traders' advantage might seem unfair, but it's not unfair in the same way as insider trading. In the latter case, privileged information is available only to a limited group -- company executives, for example -- who break the law if they use it to make money at the expense of less-informed investors. In the former, the information is available to anyone willing to pay. It's akin to paying an airline for the privilege to board a flight early, or -- just to emphasize a previously disclosed interest -- to buying a subscription to a Bloomberg terminal.
On a more practical level, most of the advantage will remain even if Schneiderman manages to make access to information more equal -- as he has already done by pressuring news-release distributors Business Wire and Marketwired to get rid of their direct feeds. High-frequency traders will still be a lot faster than investors who don't make the same investments in technology. Eliminating the advantage would require draconian measures.
The more important issue is whether, in their incessant efforts to identify opportunities and get to the front of the line, high-frequency traders are harming others or presenting a threat to the financial system. Research suggests that they can actually help individual investors by lowering transaction costs and making sure market prices accurately reflect available information. But they might also make trading more expensive for institutions, such as mutual funds and pension plans, by anticipating and piling in ahead of big trades. Most troubling is the possibilitythat many algorithms interacting at such speed might bring about a market meltdown, of the kind that nearly occurred in the Flash Crash of 2010.
If Schneiderman's investigation helps answer those questions, it will do investors a service. So far, it seems to be going in a different direction -- fast.
--Editors: Mark Whitehouse, Clive Crook.
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