October 27, 2011
TO: Mary L. Schapiro, Chairperson
Dear Ms. Schapiro,
From the standpoint of public policy on financial markets, the practice of high frequency trading (HFT) has been tolerated - or even encouraged - by government regulators. The justification for the policy stems from the argument that a groundswell of trading bolsters the efficiency of transactions in the marketplace.
Upon closer inspection, though, the gainful result does not ensue in the case of predatory schemes. A prime example lies in hyperactive trading that involves market manipulation in tandem with needless volatility.
In the olden days, a throng of independent actors in the market placed their orders on a manual basis. In the process, the participants would take account of relevant cues such as the current price of an asset.
In the modern era, however, a growing share of transactions is conducted by digital robots whose aim is to subvert the natural process of price discovery along with the lucid allocation of capital. The deception in the marketplace is in fact the true source of profit for the players in high frequency trading. Moreover, due to the cost of building the predatory software, HFT has turned into the preserve of gigantic institutions armed with immense budgets.
As part of the automated campaign, fictitious orders are sent out by the digital agents for the specific purpose of sounding out the reservation prices of other participants in the market. The next step is to take advantage of the other actors, including human investors, before the general public has the opportunity to process the relevant information and act accordingly.
To make matters worse, the windfall garnered by HFT firms occurs in tandem with a crankup of volatility in the marketplace. Moreover, the gush of profits is generated at the expense of the investing public rather than the outcome of any contribution to the efficiency of the market.
In fact, the standard operating procedure of the manipulators is to mask the price signals to the greatest extent possible so that they can take full advantage of the other players. By reducing the amount of information available to the general public, the raiders end up cutting down the efficiency of the market.
To top it off, the transfer of wealth from the investors to the raiders is a wasteful process that slashes the total amount of wealth available to the entire community. The shrinkage of wealth in the market as a whole represents another source of inefficiency in the financial arena.
These and kindred issues are discussed at length in a recent book published by myself. In particular, Chapter 7 - titled "Ambush of the Algos" - deals with the destructive effects of algorithmic traders engaged in high frequency trading.
I believe that the guidebook lays out the problems, along with promising directions for reform, in a cogent and meaningful way. For this reason, I would like to offer you a copy of the electronic book with my compliments.
You will find a detailed description of the volume at the Web page linked to the following address:
a.mintkit.com/wildc
Moreover, you are invited to download a copy of the book via this link:
a.mintkit.com/wf12j
I hope you find the book to be interesting and worthwhile.
Looking at the larger picture, the guidebook surveys the dangers in financial markets due to the profusion of predatory speculation and other harmful schemes. Despite the changes in regulation drummed up in recent years, the financial system has plenty of room for running into worse fiascos in the years to come. An example in this vein is a blowup of the stock market that shatters the entire economy and makes the global recession of 2009 look like a minor nuisance by comparison.
The enormity of the threat stems from the fact that the fundamental causes of the instability in the marketplace have not been blunted in a serious way, let alone uprooted. The festering ailment is spotlighted by the lopsided pattern of reward and penalty in the financial sector, which sets the stage for additional smashups in the future.
For these reasons, the sprinkling of measures taken thus far leave plenty of room for further bombshells in the future. In fact, the blowups to come may well surpass the financial crisis of 2008 in the devastation they cause - not only to investors and financial markets, but the real economy along with the entire population of producers and consumers.
Given this backdrop, a sound approach to financial reform has to involve a sweeping revamp of the financial system. To this end, the program of restructuring requires an overhaul of the regulations from the ground up, along with measures to protect genuine investors as well as correct the warped incentives for rabid speculators.
To round up, high frequency trading gives rise to a net loss of wealth for the financial community as a whole. The cutdown springs from the friction entailed in the surreptitious transfer of wealth from the investing public to the market manipulators.
Moreover, the pump-up of volatility decreases the stability of the financial markets. The types of markets subject to manipulation in this fashion include basic assets such as common stocks as well as derivative instruments such as futures contracts.
In a nutshell, the predatory schemes result in the loss of wealth to the financial community in the aggregate. Another impact is a cutdown of stability due to an upsurge in volatility.
For these reasons, high frequency trading ought to be strongly discouraged as a matter of public policy. Better yet, the baneful practice ought to be banned outright.
If you have any questions, comments or suggestions, please feel free to get in touch with me.
Sincerely,
Steven Kim