Robert Kuttner: High-frequency trading is just insider trading

Wall Street on Speed

By Robert Kuttner
HuffingtonPost.com, New York
Sunday, July 26, 2009

http://www.huffingtonpost.com/robert-kuttner/wall-street-on-speed_b_2451...

The New York Times recently reported that the latest scheme -- or scam -- on Wall Street is something called high-frequency trading. Very sophisticated financial firms, such as Goldman Sachs, are tipped off by the New York Stock Exchange's own computers to pending buy and sell orders. Armed with ultra-sophisticated computer algorithms, the insiders anticipate the direction of the market based on what they learn about supply and demand for a given security. They can make an extra penny here and an extra penny there at the expense of us suckers, adding up to billions.

"Nearly everyone on Wall Street is wondering how hedge funds and large banks like Goldman Sachs are making so much money so soon after the financial system nearly collapsed," wrote the Times' Charles Duhigg in a front-page piece that was the talk of New York and Washington. "High-frequency trading is one answer."

As debates in the blogosphere in the last couple of days have made clear, there are a couple of possibilities of what is at work here. One is that Goldman and others are literally using privileged information to make trades ahead of markets, in which case they are committing a felony. Specifically, the abuse is known as "front-running," or trading ahead of customers, and it is an explicitly illegal form of market manipulation. Front running is epidemic on Wall Street -- the whole point of an investment bank trading for its own account is to take advantage of its specialized knowledge of markets -- and the Securities and Exchange Commission or the Justice Department shuts down front-running when it becomes too blatant to ignore.

The other possibility is that the Goldmans of the world have found themselves a nice loophole. Tapping into the stock exchange's own computers and other sources of trading activity is something that anyone in theory could do, but only a few privileged insiders have the sophistication to exploit what they find. Often orders are placed, only to be canceled. Their purpose is to figure out what the market is willing to pay, and then get in ahead of it.

But suppose that high-frequency trading doesn't violate any law. It still is the essence of what's wrong with the recent metastasis of money markets into private game preserves for insider traders.

Consider for a moment some first principles. The legitimate and efficient function of financial markets is to connect investors to entrepreneurs, and depositors to borrowers. There is no legitimate reason whatever for this to be done by the millisecond. At bottom, the process is pretty simple. The intermediary -- the bank, savings institution, or investment bank makes its fees for making a judgment about risk and reward. How likely is the loan to be paid back? How high an interest rate should it charge? How should a new issue of securities be priced? The investor decides whether to indulge a taste for risk or for prudence.

But the hyperactive trading markets and creations of recent decades such as credit default swaps and high-speed trading algorithms add nothing to the efficiency of financial markets. They add only two things -- risk to the system, and the opportunity for insiders to reap windfall profits.

Therefore, whether or not Goldman's lawyers have figured out how it can engage in high-frequency trading and stay within the law, there is a strong case that this entire brand of financial engineering should be prohibited. The whole game should be slowed down. Bona-fide investors should get in line under the rule of first come, first served. Anything else should be considered illegal market manipulation. No dummy transactions. There is absolutely no gain to economic efficiency from having prices of securities change in milliseconds, and much gain to the opportunities for manipulation.

The need to restrain traders from exploiting their privileged knowledge is an old fight. During the New Deal, for example, many reformers proposed that floor specialists for investment bankers and brokerage houses simply be prohibited from trading for their own accounts. They should be there simply to execute buy and sell orders for customers. Otherwise, the conflict of interest would be overwhelming -- and this was before computers. These reformers were overruled, but insider trading was explicitly prohibited (and good luck catching it.)

Now, as then, it is a mark of Wall Street's stranglehold on politics that the most sensible of remedies seem impossibly radical. One very good way to damp down the dictatorship of the traders, and raise some needed revenue along the way, would be through a punitively high transactions tax on very short term trades. Genuine investors should get favored fax treatment. Pure traders should be taxed, and very short term manipulation taxed into oblivion.

If the financial crisis has proven anything, it is that capital markets have become an insiders' game in which trading profits crowd out the legitimate business of investment. The whole business-models of the most lucrative firms on Wall Street are a menace to the rest of the economy. Until the Obama administration recognizes this most basic abuse and shuts it down, it will be more enabler than reformer.

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Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. His recent book is "Obama's Challenge.")

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