Does High-Speed Trading Hurt Investors?

"Our financial system is much safer now because Wall Street has removed the weakest link--man."

-Stephen Colbert

One of the more heartwarming verities about our globalized, tightly coupled, warp-speed financial markets is that more information is better than less, thus more information technology means more-efficient markets on more-level playing fields.

But what if technology actually tilts the playing field and impedes efficiency? Lots of people say that's exactly what "high-frequency trading" (HFT) is doing, and that average investors like you will ultimately pay the price.

HFT--actually a generic term for a range of high-speed trading tactics--is the fine art of using powerful computers programmed with complex instructions to trade stocks at lightning speed, seeking profits in tiny price discrepancies that might exist for a fraction of a second. Also known as "black-box" and "algorithmic" trading, it involves the programming of computers by "quants" (for quantitative analysts) to buy this or sell that in response to information--some market trend or piece of news--getting into and out of a stock faster than a human can click a mouse. These trades might make a fraction of a penny per share, but do that millions of times a day and it adds up to real money.

HFT has nothing to do with investing, as most people understand the word, even if it can have an impact on investors. The quants and their computers usually know nothing of company fundamentals--business models, management bios, balance sheets, and whatnot. They trade based solely on statistically informed instructions called algorithms. A successful HFT operation will make almost as many losing bets as winning bets, but the huge volumes involved can make even razor-thin margins profitable in the aggregate.

[Read: That Rumbling in Your Portfolio? It's Real.]

Once a marginal part of market activity, in the past five years HFT has grown to represent half to three-quarters of a typical day's trading volume, even if HFTs themselves represent only 2 percent or so of investors. Among the chief beneficiaries are brokers and dealers, who get a slice of each trade and cater increasingly to HFT clients. Most HFT shops are standalone affairs, like Red Bank, N.J.-based Tradeworx, while a few are arms of big institutions such as Goldman Sachs.

Whoever the players, the name of the game is speed, and the winners are the folks who get information a few milliseconds before the losers--i.e., the people with the fastest computers and the lowest "latency" (the time it takes to transmit data). As the game boils down to how fast electrons can travel, latency is becoming a function of "co-location"--setting up shop as close as physically possible to the exchange servers that are the source of raw price data. NYSE Euronext sells space at its Mahwah, N.J., "Liquidity Center" to HFT outfits.

Technology has thus created what many complain is a new class of insiders--those who can afford the computer systems necessary to monitor "order flow" a few milliseconds before the competition, and siphon off the profits that result.

Does any of this matter to a typical retail investor? Yes, in good ways and bad. The upside of what might look like a post-human, vaguely Orwellian battle between armies of robots is a sharp improvement in what market professionals call "liquidity"--essentially the ease with which you can buy and sell a stock. With so many securities flying in so many directions at such high speeds, it's a rare buyer who won't find a seller, and vice versa, on a typical trading day.

HFT has also slashed trading costs by more than half, by one reckoning. Brokers and dealers benefit anyway, because the huge expansion of volume offsets the decline in commissions.

And the downside? Critics say the whole objective of HFT is to secure an information advantage over everyone else. Never mind that in the perfectly efficient market that purists like to imagine there aren't supposed to be any informational advantages. They do exist, and spotting them can allow for "front running"--exploiting price movements that you know about in advance--and other forms of market manipulation. There's reason entrepreneur Mark Cuban famously called HFTs "the ultimate hackers."

[Read: Are You Vulnerable to Computerized Markets?]

But the bigger problem may be systemic risk, as exemplified by the "flash crash" of May 6, 2010, and the $440 million loss incurred by Knight Capital in August as the result of a software glitch. There is an analogy to be made between the argument over HFT and that other tiresome acronym, TBTF. Too-big-to-fail banks defend themselves by arguing that they offer efficiencies smaller banks can't. Even Alan Greenspan has dismissed that claim. But even if the banks are right, there's the question--posed by Republican presidential candidate Jon Huntsman, among others--of whether the cost of the systemic risk they pose exceeds the benefits of the efficiencies. Likewise with HFT.

To be sure, some argue that they do not increase systemic risk. The most prominent defender of HFT practices, Tradeworx CEO Manoj Narang, argued in 2010 comments to the Securities and Exchange Commission that in a pinch, HFTs--unlike longer-term investors-- can simply "turn off" their trading strategies and unwind their positions (something they effectively do at the close of each trading day anyway), "thereby eliminating any possibility of further losses" and immunizing them from the contagions that can afflict big quant firms. He also wrote that critics exaggerate the likelihood of "runaway algorithms" accelerating a meltdown, saying exchange rules and market regulations "eliminate most of the risk."

Narang concedes in emailed comments that "large orders executed algorithmically could pose a systemic risk if the technology is faulty, but this is not high-frequency trading. High-frequency traders hold small positions in their inventory and do not execute large trades." Flawed technology, he says, is what explains the flash crash, in which HFT "had at best a peripheral role." As for the Knight debacle, he says, "there was never any systemic risk to the stock market."

Maybe, but others argue that systemic risk is less a function of how HFTs actually operate and more about how markets perceive their activity, fairly or not.

[Read: October Sell-Off, Anyone? The S&P's 10 Worst Trading Days.]

"I don't think anyone believes that the default of an HFT would cause the international economy to collapse. That's not the point," says Wallace Turbeville, senior analyst at the progressive think tank Demos and author of a forthcoming study on HFTs. "HFT activity creates a perception of great liquidity in the market, but in fact HFT activity, because it's algorithmic, can switch from providing high levels of liquidity to consuming even higher levels of liquidity instantaneously. It's worse than no liquidity at all. If it can change by the flick of a switch, it's a very volatile situation."

In other words, HFTs enhance liquidity until they don't, and the uncertainty impedes investor confidence.

So, it could be that the market is in fact becoming an unpredictable casino rigged by the people who can buy the most computing power. Or it might be that investors are overreacting. As that eminent economist Stephen Colbert put it: "You destroy the global economy once, and everyone forgets all the times you didn't destroy it."

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