Michael Lewis shocked the investing public with his charge that the stock market is rigged. He will have done investors a great service if he has also shocked the Securities and Exchange Commission into re-examining high-frequency trading and taking steps to halt it.
If the SEC finds it cannot take action under current laws and regulations, Congress must step in. Institutional investors should lend their support to efforts to halt, or at least slow, high-frequency trading because they are potentially the biggest losers from the practice.
High-frequency trading doesn't rig the market in the sense that investors can't win, but it does rig the market in the sense that HFT operators take advantage of weaknesses in market structure to skim a fraction of a cent from every transaction.
Because institutional investors often trade hundreds of thousands of shares at a time, the high-frequency traders collect substantial amounts of “toll” from each trade. In addition, according to Mr. Lewis and others, the high-frequency traders get insight into what shares are about to be traded and thus can front-run the trades, adding to their profits.
The impact on investors is that the skim comes at their expense, reducing their investment return over the long run. The “skim” is much less than brokers took when trades cost as much as 7 cents a share in the "70s before negotiated commissions, but managers did much less trading then because of the costs (for better or worse), and the brokerage commission was out in the open. With high-frequency trading, the skim is hidden.
Brokers and market makers provided a service for their 7 cents. High-frequency traders provide no visible service. The amount of high-frequency traders' profits is the amount lost by investors for no good reason.
The traders, and some members of the stock exchanges, argue that high-frequency trading adds to market liquidity, to the benefit of other investors. However, if that is true, it is true only in relatively calm markets. Since at least 2008, high-frequency traders have fled the market at the first sign of trouble.
Also, when their algorithms go haywire, or fat-fingered trades get made, investors get hurt, as when Procter & Gamble Co.'s stock collapsed a few years ago because of a fat-fingered trade.
The fact that high-frequency traders gain an advantage over other investors, institutional and individual, also damages investor confidence in the stock market.
Mr. Lewis' book broke little new ground. Others before him had pointed out the dangers of high-frequency trading, but his use of the word “rigged” drew maximum attention to the practice and highlighted its abusive aspects.
Institutional investors should build on that attention and increase pressure on regulators — and if necessary legislators — to correct the flaws that make high-frequency trading the blight on the market it is.
