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It’s time to shed light on high-frequency traders

Regulators should rein in high frequency trading, a practice in which traders use sophisticated technology to buy and sell stocks at lightning speed.

The problem? High frequency trading (HFT) takes money out of regular traders' pocket by negotiating in a misleading fashion.

The problem has not gone unnoticed: This week, a Congressional committee in the United States is expected to scrutinize the role played by traders adept in this practice. And the Investment Industry Regulatory Organization of Canada has said it is also examining the issue.

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To understand why HFT is bad, compare it to other transactions.

When you bid for a home, your real estate broker gives your offer to the broker representing the seller. Your broker may know the top price you would be willing to pay, but the seller's broker doesn't, so he can't use that knowledge to your detriment.

As a purchaser, though, you have obligations. If your offer is conditional, you must specify this in advance. If it's not conditional, your bid is alive until accepted or rejected. Once accepted, you're obligated to pay and take possession. If you don't pay, you've shirked your obligation and must forfeit your deposit.

The stock market doesn't work quite the same way.

Assume you are a pension fund wishing to buy a large block of shares. You know your order may "move the market" – boost the share price – so you instruct your broker to post an initial low bid on the exchange and see what volume of business it attracts. You tell your broker the top price you are willing to pay, but he must keep this to himself. (If you trade electronically, the process is slightly different: You would post the scaled order yourself on the exchange via a trading platform. Again, though, the initial bid is visible, but your top price is not.)

It's at this point that HFT can kick in. According to market participants I've spoken to, much of HFT's profits derive from worming out your top price via electronic negotiations that would never be allowed in most markets. Here's how.

First, the high frequency trader sends an unconditional "yes" to your offer to buy, gets an acceptance, but cancels his sell offer super-fast, before the exchange can confirm it. He keeps probing higher and higher with falsely unconditional offers, in penny increments. Whenever he gets an "acceptance," he cancels before being forced to make delivery. Once acceptances cease, he knows your top price – without having had to deliver.

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The high frequency trader can take advantage of this knowledge – for instance, by buying the stock at any level just short of the top price. He can do this with reasonable confidence that he can then sell it on to you.

These conditional offers masquerading as firm offers are bad business. They cost pensioners a piece of their pensions and they cost you a piece of your investing returns.

The problem can be fixed in a number of ways.

Some regulators propose a fee on every trading-message, to make cancellations costlier. But this would penalize honest traders too.

A better idea would be to force high frequency traders to post offers accompanied by records of their cancellations. Other traders would then know who to avoid.

There's nothing radical about this idea. Money managers like me publish their track records, corporations show their credit ratings, and Amazon and eBay vendors show their fulfilment rates. High frequency traders should do the same.

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Stock-exchanges deal with high frequency traders because HFT is a big part of their business – more than 50 per cent of exchange volume in the United States, and 25 per cent in Canada, by some estimates. But cleaning up HFT could be accomplished relatively simply if regulators got serious.

First, they could require all orders tagged as non-conditional to stay live for at least several seconds, so they can't be immediately cancelled. Some exchanges already specify this. But it should become a regulatory requirement.

Second, if a high frequency trader wants the freedom to cancel faster, he should be required to clearly tag his order as conditional – and show his ratio of orders to actual trades. Soon enough, the traders who most frequently cancel orders would find themselves shunned.

As Justice Louis Brandeis once said: Sunshine is often the best disinfectant.

Avner Mandelman is author of The Sleuth Investor .

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