A new high profile voice has been added to the high frequency trading debate.  This time it’s an industry insider and he is not too happy about what high frequency trading has been doing to the retail investor.  The new voice is none other than Charles Schwab.  Last week, in a WSJ op-ed titled “Why Individual Investors Are Fleeing Stocks” , Schwab ripped into high frequency trading, exchanges and the regulators.  Here are a few quotes from his op-ed:

“High-frequency traders are gaming the system. Using sophisticated algorithms, high-frequency traders can trade stocks in an instant. Some flood the market with orders, then cancel 90% or more once they’ve glimpsed the state of the market and gleaned an advantage. Almost all “co-locate” their computer servers as physically close as possible to those of the exchanges to cut down the travel time of information by microseconds and then trade on that tiny speed advantage.”

“Regulators need to do more to ensure that all professional traders are playing by the same rules as the rest of us. A penalty on excessive cancellations, rigorous enforcement of rules regarding information access, and a top-to-bottom study of the NYSE’s 40-year-old Market Data System would be good places to start.”

“Regulators have been slow to respond to the epidemic of market glitches large and small. Stronger steps—such as imposing “kill switches” to stop trading in a stock when a problem occurs—need to be taken to ensure that systems can detect and isolate a problem before it spreads across the market.”

Schwab contends that individual investors are walking away from the stock market because they feel the game is rigged against them.  We agree with him and have said the same thing many times in the past.  We have pointed to the continuous outflow of long term equity mutual fund money as a sign that the retail investor is fed up with the equity market. Curiously, some other market structure “experts” think that the inflow of ETF money into equity funds is a sign that retail investors don’t have a problem with equity market structure.  We would disagree and note that ETF’s are much more short term/trading oriented instruments and their flows are not a good sign of long term investor sentiment.

While we agree with Charles Schwab’s op-ed, there is one point that we would like to make about Schwab that he omitted from his op ed.  Schwab currently sends 99% of their retail order flow  to UBS.  In return for sending this flow to UBS, Schwab receives “payments for orders executed which averaged less than $.00065 per share”.  This order flow never makes it to the public markets since it is internalized by UBS.   We take issue with the fact that limit orders posted on public markets are being disadvantaged since they never have a chance to interact with retail order flow.  For example, suppose you post a $10 bid for 500 shares. One of Schwab’s retail clients may want to sell you stock at that level. They place an order to sell 500 shares at $10 and receive a fill at the price of $10.0001.  You receive a nothing done since the UBS internalizer stepped in between the trade. We think the minuscule price improvement that the retail order receives is not the real story when it comes to internalization.   We believe this internalization process is harming true price discovery and disadvantaging limit orders.

While we take issue with internalization, we are very happy to have Charles Schwab join fellow investors like Leon Cooperman, Michael Price and Warren Buffett in their quest to stop the insanity of high frequency trading before it’s too late.