High-Frequency Trading: Everybody’s Cheated

Sometimes in high finance, we get so worked up about the idea that one guy is cheating that we ignore widespread unfairness from the referees. That’s what we may be doing as we chart High Frequency Trading (HFT).

HFT mania hit the news Friday, introducing investors to a new conspiracy theory: secret trader clubs that pay exchanges to see your buy/sell orders and then trade ahead of you, shaving cents off your potential profits. With billions of shares traded daily, it adds up to millions of dollars,  said a widely-circulated story in the New York Times.

Forget for a moment how lucrative this can be: how is it legal? Front-running, the practice of getting ahead of other people’s orders, is illegal. Yet this is exactly what high frequency traders do – see your orders, get ahead of them, buy low and sell higher to you.

Sen. Charles Schumer was puzzled by this quirk as well – and since he’s a guy with actual reach, he’s asked the Securities and Exchange Commission to investigate this further.  Since participating exchanges flash their orders to HFT’s for a few hundred milliseconds before routing, they can be seen as breaking those rules. I’m no trading cop, but that seems like a violation worthy of a fine.

The heart of this matter, however, is not financial but ethical. It’s tempting to think of this as a matter of highwaymen stealing buckets of money from unsuspecting individual investors. and yes, adding a few cents to every trade does add up given billions of shares changing hands every day.

But if the market system is to function successfully, it can’t do so without integrity.  The one key role of public exchanges is price discovery. By herding the buyers and sellers to a central trading hub, exchanges exist to create a fair system for divining asset prices by majority rule. When a small minority gets to see and trade ahead of the rest, faith in the entire system falters.

Which means that whatever the HFT hotshots pocket, an exchange that allows such mischief leaves the financial system poorer.