Tuesday, August 18, 2009

Don't Set Speed Limits on Trading - Why penalize efficiency? It creates deep and liquid markets

Don't Set Speed Limits on Trading. By ARTHUR LEVITT JR.
Why penalize efficiency? It creates deep and liquid markets.
WSJ, Aug 18, 2009

The debate over high-frequency trading may seem remote and irrelevant to small investors. After all, they may think, if you're only buying and selling stocks and mutual funds occasionally, what difference does it make whether some traders are able to move quickly in and out of those same stocks, squeezing an extra penny or two of profit here and there?

But this debate is not just about the rarified world of high-frequency traders, dominated by superfast computing and trading by advanced algorithms. It's fundamentally about the competitiveness and health of U.S. markets, and the ease with which all investors are able to find willing buyers and sellers. Small investors may never directly use a high-frequency trading strategy in their lives, but they have a very large stake in whether such strategies are regulated out of existence, as is now urged by some in Congress, the media and Wall Street.

High-frequency trading is, in many respects, just the next stage in the ongoing technological innovation of financial markets. Just as paper tickets for trades were replaced by computer orders, and the trading floor seen on television was made largely irrelevant by electronic exchanges, so has high-frequency trading revolutionized the way most U.S. stocks and related investment products are priced and sold.

High-frequency trading occurs when traders position very fast computers as close as possible to the stock market's computer servers to minimize the distance and time it takes for an order to pass through telecom lines. The traders then program those computers to analyze and react to incoming market data in mere fractions of a second.

Those fractions of a second translate into only slightly better margins in executing trades, but if done in large enough volume they add up to significant value. Because of that, roughly two-thirds of all U.S. daily stock volume is generated by high-frequency traders.

Due to the rise of high-frequency trading, investors both large and small enjoy a deeper pool of potential buyers and sellers, and a wider variety of ways to execute trades. There are today more than 30 execution venues—ranging from established global exchanges to a plethora of specialized markets—catering to the particular trading needs of institutions and individuals. Choice abounds, and investors now enjoy faster, more reliable execution technology and lower execution fees than ever before. All of that contributes significantly to market liquidity, a critical measure of market health and something all investors value.

Normally, this revolution in trading would be welcomed, but the practice of "flash trading," which has recently garnered negative headlines and regulatory action, has led some market observers to condemn high-frequency trading as a whole. This is a mistake. While I support the move to ban flash orders because they have the potential to undermine the goals of market competition, that does not mean we should demonize or regulate out of existence all high-frequency trading.

Some in Congress have suggested a tax on all trades of up to 25 basis points per trade, which would raise the per-transaction price on the purchase of a $20 stock to five cents from less than a penny now. Such a tax has been tried before—from 1914 to 1966, there was a transfer tax set at 0.2% on stock trades. But that expense was simply passed on to investors. Today, a tax on each stock transaction would probably drive high-frequency traders, and the liquidity they bring, to foreign markets.

Others simply assert that all high-frequency trading has no moral or underlying economic value, and that high-frequency trading is simply a game for those who want to profit from getting access to data a split-second ahead of someone else. The Securities and Exchange Commission should ignore these complaints and the caricature that has developed of high-frequency traders.

These traders have developed systems to allow them to beat the competition to displayed quotes. They have taken available space near the markets' data servers to squeeze time out of every transaction. These traders continuously look for inefficiencies, and by exploiting them, correct them. I see nothing sinister or unfair about the advantages that come out of their investments and efforts.

We should not set a speed limit to slow everyone down to the pace set by those unwilling or unable to compete at the highest levels of market activity. Investors large and small have always been served well by those looking to build the deepest possible pool of potential buyers and sellers, make trades at a better price, and all as quickly as possible.

More liquidity, better pricing and faster speeds are the building blocks of healthy and transparent markets, and we must always affirm those goals.

Mr. Levitt was chairman of the Securities and Exchange Commission from 1993 to 2001.