We’ve been following the HFT story since Zero Hedge first shed light on this unfair practice and noted that the market is increasingly dominated by program trading between investment banks. The article below from Money Morning shows that this issue has finally become well-known and market participants are seeking solutions. 
Consider Phil’s example from Wednesday’s market update:
"The lack of a retrace was getting downright unhealthy. As I often complain – rapid rises in the market, especially when accomplished through what we call “stick saves” create virtual air pockets in stock prices and make investing more and more dangerous as we move up. A simple example I use for members is to imagine the stock market has just 100 total shares. In March, those 100 shares were worth $1,000 and there was $1,000 sitting on the sidelines in cash. Shares are bought and sold every day but it doesn’t really matter as they are never all bought or all sold. The bottom line is that perhaps 25% of the cash actually moved off the sidelines but the market has gained 50% since March. Where does that leave us? Well that means we now have 100 shares of stock “worth” $1,500 but now there is only $750 on the sidelines to buy it.
That makes it exponentially harder to move the market higher as the values grow as it takes more and more sideline capital to grow the market each day… In fact, the entire expansion of “value” of the market is an illusion as it WAS possible in March to exchange 100% of the stocks for the cash on the sidelines for $1,000 (assuming everyone on the sidelines would make the trade). Now that we have USED 25% of the sideline money to inflate the apparent value of the stocks, we have a serious problem because, even if EVERY SINGLE DOLLAR of sideline capital were exchanged for stocks in a panic sale, there is only enough to pay out 50% of the market’s current ‘value.’"
So, are HFT programs being used to increase the price of stocks on a daily basis? How? If, for example, GS keeps the bid artificially high and moving higher in its program trading, stock prices will rise due to GS’s volume dominance. Stock prices keep rising, but not because each share has been traded at these inflated levels, but because a small fraction of most recently traded shares were marked up higher. As Phil shows in his example, there’s less money on the sidelines available to support inflated prices. What about the profits achieved from HFT and pushing the market higher? Those profits result in great earnings for the players and can be taken out of the system. So while we may believe wealth has been created by the market’s ascent, much of the money generated may be gone while support for higher prices does not truly exist.
In addition, Tyler Durden made the following observation: "Another interesting side effect that nobody talks about is how many equity follow-on offerings we have had. Ironically those peaked in June and have been sliding since. In other words, investors are unwilling to convert stock currency for cash currency. Stocks can be at 10,000 but that does not mean companies benefit from this, and in fact quite the opposite: a major trace down will have to happen before companies which are burning thru a lot of cash can access the new money on the sidelines. Absent that we will have a Nordstom’s at $100/share and with no capacity to raise any new capital. Amazing dislocation."
– Ilene
High Frequency Trading: Wall Street’s New Rent-Seeking Trick
Martin Hutchinson
Contributing Editor, Money Morning
Goldman Sachs Group Inc. (NYSE: GS) disclosed recently that it had 46 "$100 million trading days" in the second quarter of 2009. That was a record number, even for one of the biggest players on Wall Street. When the U.S. economy is facing collapse and merger and acquisition volume is way down, it seems odd that investment banks like Goldman had record quarters.
Well, here’s the secret: They’ve found a new way to skim more of the cream off the top of U.S. economic activity. It’s called "High-Frequency Trading" (HFT).
High-frequency trading uses the speed of supercomputers to trade faster than a human trader ever could. Human owners of the supercomputers program them to take advantage of information milliseconds faster than other computers, and whole seconds faster than ordinary human traders. This is not a minor development; HFTs now represent about 70% of the trading volume in the U.S. equity market.
HFT computer servers are able to beat other computers because they are located at the exchanges. They take crucial advantage of the finite speed of light and switching systems to front-run the market. They also gain information on orders and market movements more quickly than the market as a whole. They operate not only on the New York Stock Exchange (NYSE), but also on the electronic trading exchanges such as the NYSE hybrid market.
According to a paper "Toxic equity trading order flow on Wall Street" by the brokerage Themis Trading LLC, there are a number of different types of HFT. Liquidity rebate traders take advantage of volume rebates of about 0.25 cents per share offered by exchanges to brokers who post orders, providing liquidity to the market. When they spot a large order they fill parts of it, then re-offer the shares at the same price, collecting the exchange fee for providing liquidity to the market.
Predatory algorithmic traders take advantage of the institutional computers that chop up large orders into many small ones. They make the institutional trader that wants to buy bid up the price of shares by fooling its computer, placing small buy orders that they withdraw. Eventually the "predatory algo" shorts the stock at the higher price it has reached, making the institution pay up for its shares.
Automated market makers "ping" stocks to identify large reserve book orders by issuing an order very quickly, then withdrawing it. By doing this, they obtain information on a large buyer’s limits. They use this to buy shares elsewhere and on-sell them to the institution.
Program traders buy large numbers of stocks at the same time to fool institutional computers into triggering large orders. By doing this, they trigger sharp market moves.
Finally, flash traders expose an order to only one exchange. They execute it only if it can be carried out on that exchange without going through the "best price" procedure intended to give sellers on all exchanges a chance at best price execution. The Securities and Exchange Commission (SEC) has now promised to ban this technique, and flash trading on the Nasdaq will stop on September 1.
This toxic trading has caused volume to explode, especially in NYSE listed stocks. The number of quote changes has also exploded and short-term volatility has shot up. NYSE specialists now account for only around 25% of trading volume, instead of 80% as in the past.
The bottom line for us ordinary market participants is that insiders are using computers to game the system, extracting billions of dollars from the rest of the market. While it is illegal to trade on insider knowledge about company financials, these people are trading on insider knowledge about market order flow. That’s how Goldman Sachs and the other biggest houses make so much from trading. By doing so they are rent-seeking, not providing value to the market.
There are two ways to stop this: Ideally, the SEC will employ both. First, they can introduce a rule that all orders must be exposed for a full second. That will reduce the volume of HFT, but still doesn’t truly protect non-computerized outsiders.
The second, and better, solution is to introduce a small "Tobin tax" on all share transactions. It could be tiny; maybe 0.1 cents per share. (The SEC would also need to ban "exchange rebates" to traders.) Such a tax would make the worst HFT types unprofitable without imposing significant costs on retail investors. It would also provide funds to help run the vast apparatus of regulation and control that seems to be necessary to run a modern financial system.
Goldman Sachs, and other financial institutions of its ilk, have imposed huge costs on the U.S. public with their "too big to fail" status. Now they are adding to the problem by scooping out money from the stock market through HFT. It’s about time the government imposed some taxes to stop the worst of these scams and recover the public some of its money.
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Note from Money Morning’s Editor: China is Investing Billions in Renewable Energy One firm has already built China’s largest wind turbine manufacturing factory. And it’s working with the Chinese Science Academy to develop new wind, solar, and geothermal technologies… for which it will own 70% of the rights. Click here for the full report.
