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Dent the rent

31 March 2014 By Martin Hutchinson

High-speed traders are just the latest to earn opprobrium as market rent-seekers. In his new book “Flash Boys,” Michael Lewis claims they are rigging U.S. equity markets. Even Goldman Sachs Chief Operating Officer Gary Cohn acknowledges concerns. New rules, taxes or structures could reduce the high-frequency traders’ unfair advantages.

Electronic trading has proliferated in recent decades. Writing in the Wall Street Journal on March 20, Cohn noted there are now 13 public exchanges and nearly 50 alternative trading systems. These are interconnected. But payments for order volume, different trading and disclosure protocols and even variations in the time it takes optical fibers to transmit information to different venues also fragment the market, providing arbitrage opportunities.

Meanwhile, an explosion of computing power has brought algorithms that enable traders to analyze order flow and market movement almost instantaneously. Lewis suggests phenomena like phantom orders, withdrawn before they can be hit, create a less stable market than in the past and more scope for rent-seeking.

Before exchanges were automated, flesh-and-blood stock exchange specialists similarly profited from their knowledge of the queue of orders. So in one sense super-fast traders are only collecting a modern version of the same rents, in exchange – at least sometimes – for providing liquidity.

High-frequency trading may even add less to trading costs than the human interventions of old. The exploitation of the new trading infrastructure also mostly seems legal. Yet disappearing orders, which Cohn too sees as a problem, don’t represent real liquidity and suggest action may be needed to stop profits growing unchecked.

Lewis points to the early popularity among buyside investors of a new exchange, IEX, which delays its customers’ orders so that they reach all venues at the same instant thereby avoiding any risk that high-frequency traders can act before instructions reach their destination. With the Securities and Exchange Commission reviewing its rules and Eric Schneiderman, the New York State attorney general, among the other watchdogs taking an interest in high-frequency trading practices, the full gamut of reform options could come into play.

Regulation could address phantom orders or, for example, require that instructions reach all trading venues simultaneously. Taken further, that kind of approach might almost result, in essence, in the consolidation of all orders back into one marketplace – only this time a virtual one in the cloud rather than a bricks-and-mortar edifice on Wall Street.

Alternatively, a modest “Tobin tax” on all transactions – perhaps of the order of 0.01 percent – would discourage high-frequency buying and selling while barely affecting longer-term traders. The trick is to eliminate the worst rent-seeking without badly reducing market liquidity, or the ability of genuine risk-takers to make money providing it.


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