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Two Must Read Articles

18

May, 2010

USA TODAY: Our View on Wall Street: Time to put the brakes on high-frequency trading

Although this month’s “flash crash” on Wall Street has yet to be fully explained, the machine-driven market meltdown has cast an unflattering light on something called high-frequency trading.
OPPOSING VIEW: Safe at any speed

High-frequency trading uses sophisticated computer algorithms to determine when a stock is likely to tick up or down. Some of these systems buy and sell hundreds of times in the space of a second, making tiny profits each time. By some estimates, high-frequency trading now accounts for more than half of all stock market volume.

Even if superfast trading wasn’t the direct cause of the May 6 episode — attention is focusing on the interplay of differing rules among the various exchanges — the heavy volume of computer trading undoubtedly amplified the problem. In the future, it could increase the odds of another, more severe event that further undermines investor confidence.

And for what? Rapid-fire trading serves no larger purpose. It does not raise capital for companies, create jobs or stimulate innovations in the broader economy. The trades are completely divorced from underlying economic fundamentals, and the traders know little or nothing about the companies their computers are feverishly buying and selling.

In addition to their potential for wreaking havoc, high-frequency traders impose costs on more traditional investors. By jumping in and out of securities in search of dips, they decrease the chances that a conventional investor might get a stock on a down tick. A study by the accounting firm Grant Thornton concluded that “the current stock market model forces Wall Street to cater to high-frequency trading accounts at the expense of long-term investors.”

Making matters worse, these traders sometimes enter into murky ethical areas. The Securities and Exchange Commission is already trying to stop so-called flash orders, the superfast posting of potential trades used to improperly gain information before others. With a veritable arms race of new players and faster computers, it is not hard to envision more of this type of trickery taking place in the future — all too fast for human supervision.

High-frequency trading might also be diverting Wall Street’s attention from more productive activities, such as underwriting initial public offerings of stock. It is certainly diverting computer engineering talent that could be put to far better use at companies such as Google or Microsoft.

For these reasons, high-frequency trading should be discouraged. Perhaps the easiest way to do this would be to require that exchanges charge more for orders. If superfast traders had to pay what you do to make a transaction with your Schwab or E-Trade account, you can bet it would put a damper on their hyperactivity.

Backers of these traders, who range from geeks in garages to titans such as Goldman Sachs, argue that they provide a service by adding “liquidity” to the market. This is true. But it is also a clever way of saying that what these traders do — increase trading volume — is inherently a good thing.

It is not good if it can cause a market crash. It is not good if it means those with the fastest computers get the best deals. And it certainly isn’t good if it means those with the fastest computers can manipulate the system to their advantage, leaving the impression that the stock market is a rigged game for Wall Street sharpies.

Project Syndicate: Man against the Machine:

A Man against the Machine

WASHINGTON, DC – America’s financial sector has shown renewed strength in recent months – political strength, that is – by undermining most of the sensible proposals for banking reform that remain on the table. If we are still making any progress at all, it is because of the noble efforts of a small number of United States senators.

Most notable has been the work of Senator Ted Kaufman, a Democrat from Delaware (yes, a pro-business state), who has pressed tirelessly to fix the most egregious problems in the US financial sector. Kaufman understands that successful reform requires three ingredients: arguments that persuade, the ability to bring colleagues along, and a good deal of luck in the form of events that highlight problems at just the right time. On two fronts, Kaufman has – against long odds – actually managed to make substantial steps.

Long before it became fashionable, Kaufman persisted with the idea that the US real estate boom was fueled in part by pervasive fraud within the mortgage-securitization-derivatives complex, effectively at the heart of Wall Street. This thesis is now gaining much broader traction – major newspapers now report a broadening criminal probe by the federal government – and by New York’s state attorney general – into the US financial sector’s residential lending and related securities practices.

With Senators Patrick Leahy and Chuck Grassley, Kaufman worked last year to pass a bill providing timely resources to federal law enforcement agencies working on recent financial fraud. More recently, Kaufman was devastating in his cross-examination of Goldman Sachs executives. Senator Carl Levin, chairman of the subcommittee that heard their testimony, evidently seeing eye to eye with Kaufman, was just as tough after a year-long investigation of Washington Mutual, Goldman, and the abject failures of bank regulators and credit rating agencies.

Kaufman scored an even bigger coup with his warnings about the dangers of the explosive growth of high-frequency trading, which is little understood by America’s main financial watchdog, the Securities and Exchange Commission (SEC), and poses systemic market risk. His concerns appear to have been vindicated by the 20-minute shutdown of trading in New York on May 6, when the stock market completely failed in its most basic function: price discovery between buyers and sellers.

We do not yet know what combination of black-box computer programs and electronic trading algorithms, interacting across more than 50 market centers, caused this catastrophe. But our lack of knowledge itself confirms how far our regulatory and surveillance capabilities have fallen behind “financial innovation.”

Kaufman’s approach – with speeches on the Senate floor as a central feature – seemed irrelevant or even quaint to critics even a few weeks ago. No significant Wall Street voices acknowledged his concerns – preferring instead to praise the equity markets as a shining example of well-functioning technology.

Now people get it. As Senator Mark Warner graciously acknowledged, “The Senator from Delaware sounded an early warning signal that the massive amounts of investments that had been made by certain firms to try to get what appears to be a fractional millisecond advantage in the trading process might come back and haunt us all… I’ve been proud to follow his lead.”

The SEC was once a great and powerful independent agency. It fell on hard times in recent decades and is only beginning to get its act together under new leadership. Yet it still does not routinely collect the data that it needs – trades by time and customer – to understand the actions and impact of large traders. Kaufman has consistently pressed them to do more – and do it much faster; to be sure, they and many others are now listening.

On a third issue, the results so far are mixed. Kaufman championed the case for making America’s biggest banks smaller, as part of comprehensive financial-reform efforts. His advocacy helped build support and forced a Senate floor vote on an amendment, co-sponsored with Senator Sherrod Brown, that would have imposed a hard cap on banks’ size and leverage (debt relative to assets).

The amendment was moderate and entirely reasonable, yet it went down to defeat, 33-61, also on May 6. It might have gained more support just a few days later – after senators witnessed the bailout of the giant eurozone banks. Still, it has strengthened backing for another amendment, sponsored by Senators Jeff Merkley and Carl Levin, which would restrict proprietary trading by megabanks for their own account – coincidentally a practice that is presumed to be a large and “dark” part of high-speed trading.

The deeper and overriding point of Kaufman’s critique of our system is the need for tough laws. We cannot merely rely on regulators to do the right thing. In particular, regulators have no chance to look over the horizon and act preventively when markets are opaque, and when powerful Wall Street interests (and their Capitol Hill allies) can circle the wagons and claim that there is no problem.

Unfortunately, despite his newfound prominence on the national stage, Kaufman will be out of office at the end of this year – he was appointed to fill Vice President Joe Biden’s seat at the end of 2008 and committed at that time not to run for re-election.

When he goes, dangerous elements on Wall Street will no doubt breathe a sigh of relief. Let’s hope that by then he will have helped move the consensus permanently among his colleagues – preparing the ground for further congressional action aimed at a serious tightening of safeguards over the financial sector.

Kaufman’s lasting legacy will be a simple and powerful idea that reasonable people increasingly find to be self-evident: relying on deregulation and self-interest in today’s complex, opaque markets will manifestly fail to produce a reasonable allocation of capital or support entrepreneurship and growth. We must write and enforce laws that restore credibility to our financial markets.

Copyright: Project Syndicate, 2010.
www.project-syndicate.org

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