High-frequency trading merits close examination

The May 6 “flash crash” revealed an area of the financial markets that isn’t touched by the financial-reform bills in Congress but nevertheless must be examined. It is the -shadowy world of high-frequency trading, in

which 100 to 200 firms use computers plugged into the nation’s stock exchanges to trade in and out of stocks, index futures and exchange-traded funds in fractions of a second, gleaning tiny profits from each trade.

The exchanges offer rebates to the high-frequency traders for volume, adding to the profits of the firms.

High-frequency trading is the antithesis of investing, which is putting money to work for the long run. And the combination of high-powered computers, sophisticated software programs and close connections with the exchanges appear to give the firms engaged in it a significant advantage over conventional investors.

The tiny profits that the high-frequency traders make on each trade come from the pockets of other investors.

Many investors and market watchers already had been skeptical of high-frequency traders before the “flash crash,” but the sudden market plunge that day has made them even more uneasy about the activities of these traders.

High-frequency traders, and some exchange officials, claim that the traders actually help the markets and other investors by providing liquidity, ensuring that those investors can buy or sell whenever they want.

But that claim rang hollow May 6, because when the market turned down after a large, bearish S&P 500 futures trade, the high-frequency traders shut down their computers, withdrawing that liquidity when it was most needed.

The withdrawal of the high-frequency traders from the market caused prices to drop precipitously because sellers far outnumbered would-be buyers. That apparently caused a cascade of automated sell orders across the exchanges.

NO OBLIGATION

Unlike the specialists on the floor of the New York Stock Exchange, the high-frequency traders are under no obligation to continue trading when stock prices drop.

Of what use is the liquidity supposedly brought to the market by the high-frequency traders if it disappears at the first sign of trouble? If providing liquidity is the justification for the profits that they earn from their activities, then they haven’t earned them.

Sen. Edward E. Kaufman, D.-Del., is right to call for the Securities and Exchange Commission to investigate high-frequency traders and the impact that they have on the markets.

The SEC must identify high-frequency trading firms and undertake a serious study of whether their activities are helpful or harmful to the markets. If they are found to be inimical to the smooth functioning of the markets, if they increase volatility rather than smoothing it, their activities must be curbed.

Last week, the SEC filed a proposal to halt trading if individual stocks swing by more than 10%.

Although the proposed individual stock circuit breakers may alleviate the immediate problem, they won’t eliminate all concerns.

The activities of high-frequency traders May 6 harmed investor confidence. Individual investors won’t return to the stock market until they are sure that the markets are fair and that others aren’t profiting at their expense.