In the early days of stock trading prices came across a ticker tape. It posted the stock symbol and the volume. The tape ran at one speed and traders would follow the buying and selling by analyzing the tape. The great traders were able to mentally track price action and make instant trading decisions, almost like a card counter does in Blackjack. One popular past time was for investors to gather in a large sitting room and watch the ticker tape during trading hours.
Now enter the computer. Economic growth in the United States had spawned new industries and brought thousands of new stocks onto the exchanges. Trading volume grew exponentially. The computer with its speed enabled more trading and larger volumes of trades. What happened was that the speed to trading was directly related to amount of money spent by trading houses for the fastest computers. The playing field had changed in favor of the “big boys.” Let’s face it, large banks and hedge funds have millions of dollars to spend on the latest and best equipment.
At the same time traders were developing new ways of analyzing price action. They called this “technical analysis.” Large banks and institutions started hiring Ph.Ds in mathematics to develop programs that would automatically generate a buy or sell signal based on algorithms that repeated at certain intervals during the trading day. Now traders were able to keep trading almost continuously. Usually their trades make only fractions in price, however, they use the speed of their computers to trade large blocks of stocks, thus generating huge profits over time. So here again the playing field has changed.
What we have now is a new race to have the fastest computer and best algorithms, to be the “fastest kid on the block” so to speak. These high speed traders are so good that they can jump to the “head of the line” and execute trades before anyone else. They can also “see” large trades coming before they reach the exchange and “front run” or trade ahead to them. They are assured of a profit because they know in advance which way the trade is going.
A firestorm has erupted over high speed trading with the publication of Martin Lewis’ new book entitled: “Flash Boys: A Wall Street Revolt.” He contends that high speed traders have rigged the stock market, profiting from trades at a speed unavailable to ordinary investors.
The controversy as to whether or not this is legal and ethical is being investigated by a host of agencies including the FBI, the Securities and Exchange Commission, the Commodity Futures Trading Commission and now the US Justice Department. Eric Holder, US Attorney General stated: “I can confirm that we at the Justice Department are investigating this practice to determine whether it violates insider trading laws.”
Regulatory agencies are worried that this style of trading could set off another “flash crash” like the one that occurred on May 6, 2010. They are fearful that the entire security of exchanges could be affected and have no way of preventing it with the current laws. They would be left trying to undo the damage “after” such an event had occurred.
It seems reasonable to expect that new regulations will be forthcoming on this matter.