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Study: High Frequency Trading Robs From Smaller Investors

A new study confirms that high frequency trading, which already has declined in terms of its yield if not its use, endangers investors and basically turns stock markets into automated casinos where the average Joe can do little but get hurt.

The chief economist at the Commodity Futures Trading Commission, Andrei Kirilenko, reports in a coming study that high-frequency traders make an average profit of as much as $5.05 each time they go up against small traders buying and selling one of the most widely used financial contracts.

The agency has not endorsed Mr. Kirilenko’s findings, which are still being reviewed by peers, and they are already encountering some resistance from academics. But Bart Chilton, one of five C.F.T.C. commissioners, said on Monday that “what the study shows is that high-frequency traders are really the new middleman in exchange trading, and they’re taking some of the cream off the top.” […]

The study comes as a council of the nation’s top financial regulators is showing increasing concern that the accelerating automation and speed of the financial markets may represent a threat both to other investors and to the stability of the financial system.

The Financial Stability Oversight Council, an organization formed after the recent financial crisis to deal with systemic risks, took up the issue at a meeting in November that was closed to the public, according to minutes that were released Monday.

First of all, the CFTC needs to release the report. This merely confirms the expectations of most regulators, investors and observers, there’s no need for them to be cowed by Wall Street firms relying on HFT. Second, it’s sad that Kirilenko, who performed this study, is leaving the CFTC for an academic position, and that factor is probably related to the lack of release of the study and the timing of it. If Kirilenko were holding out for a revolving door position on Wall Street, this report doesn’t get written.

Third, if there’s general consensus about the increased risk and the unnecessary profit-taking from high frequency trading, fortunately we have a solution: the tax code. We can tax financial transactions in such a way that would discourage high-speed trading, because the tax burden would grow as you increase volume. That type of transaction tax can target the bond and currency markets, the new frontier for high frequency trading. This would particularly hit the most aggressive traders the hardest, which are unsurprisingly the ones generating the highest profits – some would say extraction – from the current system. These types of traders made over $45,000 a month in 2010, or $5.4 million a year. And that all comes from some other side of the bet, typically other individual investors.

There’s been a gradual yet emerging consensus that the financial markets are simply rigged for the biggest players. That will lead to their flight from investing, perhaps into darker and higher-risk markets. It would also lead to smaller profits for the algobots. Not to mention less appropriation of capital, but the idea that this is currently a feature of the stock market is little more than quaint. But certainly, regulation that discouraged the kind of distorting activity we see in high frequency trading would be preferable.

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David Dayen

David Dayen