How High-Frequency Trading Became So Controversial

High-frequency trading has moved out of the shadows and entered even the average investor's vocabulary. How did it become so controversial, and what are the pros and cons of these trading strategies?

Useless. Manipulative. A scam. An arms race. A rip off.

Google "high-frequency trading" and these are some of the headline grabbers that pop up. These juicy excerpts, of course, are mixed in with less sensational coverage that attempts to explain high-frequency trading. But the controversy is still clear.

High-frequency trading has become a common phrase in the investor's vocabulary. But most people outside the investment industry never would have even heard of it if not for the glaring spotlight shined on the financial markets in search of villains at the root of the economic crisis.

While high-frequency trading is not new to electronic traders, it grabbed the public limelight this past summer when Goldman Sachs reported stellar earnings so soon after the financial meltdown. That attention intensified as news organizations reported that a Goldman programmer was accused of stealing proprietary code from a high-frequency trading platform that potentially could be used to manipulate stock prices. So the confusion began.

Fear of the Unknown

Much of the controversy surrounding high-frequency trading can be traced to lack of a hard definition of the practice (see page 14) and of industry data to determine its scope. One executive at a high-frequency trading firm who spoke on condition of anonymity says people need someone to blame for the financial crisis, and it's natural for them to blame high-frequency traders because they don't what they do.

"I don't think who we are has been explained very well," he says, noting that as proprietary firms that trade their own money, most high-frequency shops don't have public relations branding expertise. "It might seem like high frequency trading came out of nowhere, but that's not true. There have always been market intermediaries; now they're just using computers."

As market intermediaries, he continues, high-frequency traders are essential. "As a result of high-frequency trading the markets have gotten more efficient, liquidity has improved and volumes have gone up," he contends, adding that the percentage of trading by professional market intermediaries is no greater today than it has ever been. "My perception is that this is a positive evolution of the role of market intermediaries and as a result investors have access to the best market they ever have."

According to Joseph Mecane, EVP and chief administrative officer for U.S. markets at NYSE Euronext, some of the high-frequency trading controversy developed from confusion between flash trading and high-frequency trading. "Initially there was some confusion that high-frequency trading and flash orders were the same thing, but they are very different," he says. "High-frequency trading is more of a general type of trading practice, where flash trading is a specific microstructure nuance that we didn't think was good for the market."

Mecane adds that regulators have already indicated they will be looking into flash orders and indications of interest, or IOIs, along with dark pools and that he would be surprised if flash order types were allowed to continue in their current form. "High-frequency trading is just a generic term for a type of computer-driven trading strategy -- I don't think there is any way to regulate that," notes Mecane. "What [regulators] can look at is different trading venues or practices that are being utilized."

The key difference between flash orders and high-frequency trading is based on equal access, not speed or technology investment. "The flash concept gives a certain group of traders information before its available to anyone else, and market structure needs to be set up where its level and people can get whatever information they would like at the same time," argues Mecane. On the other hand, high-frequency traders support the markets, he suggests.

"From a public policy perspective spreads are narrower and volumes are up, which are generally the things the SEC had in mind with Reg NMS," Mecane says in support of high-frequency trading. "And trading is a lot faster now."