The TMX Broadcast Centre in Toronto.FRANK GUNN/The Canadian Press
Banning high-frequency trading makes no sense.
It's a surprising message from Scott Patterson, who wrote what is probably the best book going on the issue – and one that is very critical of how markets have evolved to be dominated by high-frequency traders (HFTs). After all, the subtitle of his book Dark Pools is High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System.
But in a debate that has become almost totally polarized, Mr. Patterson acknowledges that some form of market middleman is necessary, and HFTs have taken on that role. He's no fan of how the HFT users do business and how stock markets coddle them, but he's a realist.
"You have to have short-term traders, that's what market makers always have been," Mr. Patterson said in an interview. "People that argue that HFT needs to be stopped; that's a completely ridiculous argument. If you did that you would damage the market."
Mr. Patterson's work paints an accessible and even-handed portrait of exactly how the U.S. stock trading ecosystem evolved into what he calls in the book a "Frankenstein's monster of a market."
Like most revolutions, it started with a few idealists. In this case, the main protagonist was a young programmer named Joshua Levine who in the 1990s wanted to hack the Wall Street establishment, breaking apart the cozy network of banks that tightly controlled the markets and that used their power to overcharge trading customers. He wanted to open it up, and cut out the middleman. He did that by building a revolutionary alternative to the stock market, an electronic trading network called Island that began the process of smashing the dominance of the New York Stock Exchange and the Nasdaq.
However, what Mr. Levine began as a programmer in a tiny cluttered office near the NYSE begat something that went far beyond what he could have ever intended. The old group of colluding market makers has been replaced by something that Mr. Patterson argues is just as troubling.
The markets are being run now for the benefit of high-frequency traders, in the author's view. High-frequency stock flippers and the huge volume they create are the profit engines for market operators. Mr. Patterson argues that that creates a dynamic where market operators are too easily bending to the will of the HFTs, creating such things as near-secret orders that are designed purely to make money for HFTs at the expense of the so-called "dumb money." (Read: you, me and the mutual fund and pension fund managers who handle our investments.)
"If you have a certain species that becomes dominant, if you look at it through an evolutionary lens, that's when things become somewhat toxic and things shift toward the advantage of that species," Mr. Patterson says. "You do want a diverse market in which all sorts of participants can play and trade actively and not feel like you're being disadvantaged."
There's not much nostalgia for the old days in Mr. Patterson or his book. What preceded the electronification and the computer-trading revolution was very flawed. Costs were high. Systems were slow. Insiders colluded to essentially steal from investors.
Mr. Patterson says the beginnings of the revolution fomented by Mr. Levine and his ilk led to good things.
"I readily concede that they have made the market more efficient," Mr. Patterson says. "But we have reached a point where it's highly questionable whether the marginal returns and efficiency that we're getting from this crazy tech arms race is adding anything to the broader market efficiency."
So the key now is regulation, he argues, finding a way to harness the best aspects while limiting the worst.
The problem is U.S. regulators don't know where to begin. One, the Commodity Futures Trading Commission, is currently struggling to simply define HFT.
The Securities and Exchange Commission is effectively blind. It lacks the ability to track trading and orders on all the stock markets that have sprung up in the U.S. The SEC wants to build a system to do that at a cost that the regulator says could run into the billions of dollars.
If there's good news in all this for Canada, where HFT is also rampant, it's that our regulators have the ability to see what the SEC cannot.
In the U.S., there are only guesses as to how much of the market comes from HFT activity. HFT here in Canada is about one-third of the market. We know that because there is a central system that tracks all orders and trades on all Canadian stock markets, and the country's regulators are now crunching that data further. They are trying to answer questions such as, are there predatory strategies that need be stomped out?
As Mr. Patterson says: "It sounds to me like the U.S. should be doing what Canada's doing."