Dear Regulators, It’s Time for a Speed Limit

In the 1960’s, stocks changed hands every 8 years, on average. Today, they change hands every 20 minutes, largely in part to the popularity of high-frequency trading. Italian, Japanese and Brazilian regulators have adapted to changing market dynamics. US regulators have yet to adapt, leaving retail investors vulnerable to getting ripped off.

In the early days of retail trading, value investing was a popular and reliable strategy. To build long-term wealth, investors researched the fundamentals to discover undervalued assets, then waited for them to appreciate to their market value. If they did their homework correctly, investors could expect to profit from their research and patience.

Algotrading

Source: Aite Group

However, in the last few decades, value investing has been eclipsed by algorithmic high-frequency trading, or HFT. Analysts estimate that about 70% of Wall Street’s trade volume is through high-frequency channels. The US regulatory system has no formal definition of HFT, but the strategy is generally characterized by:

  • High speed and complex algorithmic programs to place trade orders
  • Buying and selling in short time frames, often just seconds
  • Submitting orders and cancelling them before they are executed
  • Liquidating most or all positions between trading sessions.

Admittedly, high-frequency trading provides some market benefits, including enhanced liquidity and pricing efficiency. However, its popularity has distorted the playing field to the point of market manipulation, putting the average retail investor at a distinct disadvantage.

High-frequency trading disrupts the level playing field in financial markets and encourages dangerous short-term trading strategies that rely on arbitrage and speed. For example, high-frequency traders have been busted for bribing the publishers of the Consumer Sentiment Index in order to gain early access to its report. They have cut deals with banks to enter into “dark pools,” which promised to protect retail investors from the effects of high-frequency trading. These traders are uninterested in the fundamentals of the companies they invest in; rather, they seek to beat the market reaction by a millisecond and turn a quick profit.

In 2014, Athena Capital Research was hit with a $1 million penalty for project “Gravy,” a high-frequency trading algorithm that placed huge trade orders during the last 2 seconds of trading in order to manipulate stock prices every day for six months. This strategy stole from millions of Americans, whose mutual funds relied on the price of the underlying equities at market close. An SEC investigation found internal emails warning cohorts not to “kill the golden goose,” while planning trips to Vegas after especially profitable days.

Our financial system has strong regulations in place to catch old-fashioned fraudsters and insider traders, but the complexity of high-frequency trading often conceals these exact crimes under the veil of an “algorithmic” strategy. While the Athena fraud case is disturbing, the most dangerous players are likely the most covert. They have developed the most confusing algorithms, and are smart enough to avoid gluttonous nicknames for their market-manipulating strategies.

Retail investors deserve governmental protection from these toxic practices, just as they receive protection as consumers by the Consumer Financial Protection Bureau. The stock market’s dynamics have changed, and it’s time to update the rulebook. Italy has implemented a small transactional tax to discourage abusive short-term trading, and Tokyo and Brazil are following suit. American stock exchanges shouldn’t be the last ones to the table. High-frequency trading is difficult to regulate, but given its popularity and the damage done to retail investors, the time to adapt is now.

Until changes are made, retail traders must take their own precautions. To start, don’t try to play the high-frequency game. You can’t beat computerized traders, and you’re likely to get slaughtered trying. Study the trade volumes of your investments, and avoid stocks with high volume and low prices. These stocks are the darlings of high-frequency traders, so you should lean towards buy and hold strategies for these equities.

Finally, watch for algorithmic errors and pounce. Keep an eye on Walgreens ($WAG) and Hitachi ($HIT.) When a popular account tweets about “$trip club$ and dollar bill$,” human traders know it has nothing to do with Trip Advisor’s share price, but computers can slip up on these subtleties, leaving an opportunity for retail traders to beat them at their own game.

6 thoughts on “Dear Regulators, It’s Time for a Speed Limit

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