High frequency trading: Why the robots must die

    The robo-stock market blew a fuse Thursday. Now is Washington’s chance to rewire the joint for good.

    The exact causes of Thursday’s stock market short-circuit remain unclear, but the lesson is unmistakable. The regulators and the major exchanges have drifted from their original duty: to run a market that gives small companies a way to raise capital and mom-and-pop stock buyers a way to invest for the future on fair terms.

    Instead, they have created a Frankenstein’s monster that churns away for the sake of volume itself, lining the pockets of nimble, technologically savvy hedge funds, giant investment banks and other players – at the expense of market stability.

    “What happened Thursday is much worse than the market makers walking away from their phones in 1987,” said Joe Saluzzi, who runs Themis Trading in Chatham, N.J., and has been a vocal foe of the rise of computerized trading. “When the sell orders came, the buyers disappeared. That’s a broken system.”

    Saluzzi says regulators and policymakers must understand that the rise of automated trading – more than half of daily stock market volume is conducted using so-called high frequency trading strategies, according to a widely cited estimate from Tabb Group (see below for the full report) – is driving legitimate investors out of the market.

    A study last year by Grant Thornton concluded that a shift in the structure of the financial markets, toward superfast trading and away from regional independent brokerage and research, has suppressed initial public offerings by U.S. companies.

    An annual average of 122 corporate IPOs took place between 2001 and 2009, the Grant Thornton survey says. That’s down from an average of 530 between 1990 and 2000.

    The IPO market’s decline is “hurting small business by cutting off a source of capital … that in turn would drive reinvestment and entrepreneurship in the United States,” the report by David Weild and Edward Kim concludes. The report presents the collapse of IPO activity as “the perfect storm of unintended consequences from the cumulative effects of uncoordinated regulatory changes and inevitable technology advances.”

    This runs directly counter to the notion oft bandied about by the likes of Goldman Sachs (GS) that their activities – which in recent years have increasingly focused on trading – help the economy. Goldman came under fire at its annual meeting Friday for paying out huge bonuses without contributing much to struggling local economies.

    The answer, Saluzzi said, is to change a number of market practices that have sprung up in the past decade. Bid-ask spreads need to widen out to a nickel or even a dime from the pennies that are common now, he said. Thinner spreads practically beg for the high-volume abuse of automated trading.

    Saluzzi also suggests slapping a fee on traders who cancel trades, as high frequency operations often do, and changing the practice of paying traders for providing liquidity.

    Liquidity might suffer, but Saluzzi and others say the last few years suggest the highly liquid markets of the unregulated market world aren’t worth it.

    “I think it would be healthy for our markets if buyers of a stock thought they might have to hold it for a day,” value investor Whitney Tilson wrote in a note to clients Friday.

    Saluzzi doesn’t like the idea of a transaction tax, but he says there are numerous routes regulators could go to take the market back to less frothy, more sustainable ground.

    But they have to get cracking. The Securities and Exchange Commission and the Commodity Futures Trading Commission said Thursday they would investigate, but even now time is a wasting.

    “We want to see a big reaction in Washington,” said Saluzzi. “We need to get all these fast-trading jokers out of here.”