By ROGER LOWENSTEIN
Published: October 1, 2012
IMAGINE if the stock market were hijacked by computers that executed trades in a fraction of the time that it takes to blink. Since no mere mortal could understand the “thinking” behind such nanosecond trading, ordinary investors — even longtime institutional traders — would have little clue as to why any company’s share price was moving up or down in any moment. The values of well-established corporations would sometimes swing wildly from one second to the next and we slow-reacting, human investors wouldn’t know why.
You don’t really have to imagine this. This is how our stock markets function today. Some 50 percent to 70 percent of all trading is done by “traders” who live in server parks, are nourished by direct current and speak only in binary pulses.
Several other countries are starting to regulate this high-frequency trading, or H.F.T. But in the United States, the deep-seated bias toward “liquidity” — the notion that more volume will always make it easier for investors to buy and sell shares — has discouraged regulators from taking action.
Lately, though, after several well-publicized market blowups traced to H.F.T., officials are having second thoughts. In late September, the Senate banking committee held a hearing on the issue, and the Securities and Exchange Commission is getting into the act with a panel discussion today. Even Wall Street veterans have begun to question whether a market flooded with speed demons is good for society.
The purpose of financial markets, remember, is not to provide a forum for split-second trading. If you want to gamble, go to Las Vegas. Markets exist to provide some minimal level of liquidity, so that long-term investors have the confidence to invest. And they exist so that companies and investors can discover how much an ownership position in, say, Apple is worth. When Apple stock goes up, it sends a signal to other firms to invest in the same or similar technologies. Thus does a capitalist society allocate resources.
A well-functioning market can accommodate some hyperactive turnstile traders as long as it has enough legitimate investors — people who are thinking about the outlook for companies down the road.
The reason that market squares like me harp on the long term isn’t because we’re technologically illiterate. It’s because, again, society relies on the market to allocate capital. If market signals are based on algorithms that become outmoded in a nanosecond, we end up with empty factories and useless investment.
How much effort do high-speed traders devote to analyzing the future prospects of Apple? Precisely none. Their aim is only to exploit tiny price discrepancies that disappear in milliseconds.
Incredibly, we have let capital formation become subordinate to traders on electronic steroids — with some hedge funds setting up their servers just inches away from stock exchange servers to get a jump on other steroid-crazed traders. David Lauer, a former trader, told the Senate panel that high-speed technology was “a destructive force in the market” with “no social benefit.”
He’s right. The “liquidity” H.F.T. provides is long past the point of being helpful. When high-speed trading was new, trading costs for all investors seemed to dip, but that trend has stopped, suggesting a point of diminished returns. Volume on the New York Stock Exchange now is four times the level it was in 1999 — a year with so much excess liquidity that it witnessed the greatest stock market bubble in history.
And in exchange for providing the markets with more liquidity than they need, H.F.T. is creating a problem of a potentially enormous scale. It’s not just that such trading is unfair to traditional investors who, obviously, cannot take advantage of price movements they cannot see. (The truth is, parlor investors who try to beat the pros at short-term trading have always been easy fodder for Wall Street.) The greater concern is that it will subject markets to more destabilizing crashes and that prices will come to reflect the “judgments” not of investors, but of high-speed robots.
We’ve seen evidence of that already. In May 2010, several publicly traded companies briefly lost nearly $1 trillion of market value in a so-called “flash crash” that the S.E.C. said was triggered by a single firm using algorithms to rapidly sell 75,000 futures contracts. Unless something is done, the markets will grow only more volatile and less responsive to investment values.
Lawmakers in Germany, Australia and other countries are proposing to address the problem by imposing new restrictions on high-speed traders, and considering options like erecting superfast shutdown switches that might be able to cordon off damage in a crisis. But the better way to discourage this excessive, short-term market myopia is to take a page from anti-tobacco efforts: let high taxes discourage the antisocial behavior.
We already encourage long-term investing by taxing capital gains on investments held for more than a year at a rate of just 15 percent — in contrast to short-term capital gains, which are assessed at much higher rates. We could simply fine-tune that incentive even more. Intraday trades should be taxed at 50 percent. And “investments” that mature in 60 seconds should be regarded as, in effect, electronic errors — with any profit going to the government. This will greatly reduce high-speed trading and divert its remaining gains to the public.