Wall Street ripoff 2.0: High speed trading and deep, dark pools

On July 31, Senator Edward Kaufman (D - Del.) published a scathing letter online calling on the Securities Exchange Commission to make key rule changes. Titled "A Level Playing Field for Investors," the letter asked the SEC to end the practice of "flash orders" which allow large financial exchanges to preview large orders to a select group of paying customers. Kaufmann's letter also asked the SEC to force so-called "dark pools" to reveal their inner workings.

Dark pools are groupings of shares that allow large institutions to more easily trade amongst themselves and also to mask large volume trades from the broad market and prevent rapid swings in share prices. The letter minced no words, implicitly comparing the current Wall Street situation to the profound injustice of racial segregation.
Writes Kaufman:
"Regrettably, we now have an unfair playing field for investors. This leaves us with, in effect, two financial markets: one for powerful insiders, who use high-speed computers and privileged access to information to exploit loopholes for profit, and another for the average investor, who must play by the rules and whose orders are filled almost as an afterthought. This situation simply cannot continue. It is the financial equivalent of 'separate and unequal.' "
This is the second such letter to emerge within the week. On July 24, U.S. Senator Charles Schumer (D. - New York) sent a letter to the Securities Exchange Commission asking them to ban the practice of high-frequency trading (HFT). Other politicians have started to ask tough questions and many on Wall Street are beginning to object to the practice, including large mutual fund giants such as T. Rowe Price.

In response, the large exchanges and other actors in the HFT, flash order and dark pools arena are struggling to explain why it's OK for them to see exchange orders before anyone else. Their primary explanation is that they provide "liquidity." This means that having really huge companies quickly trading lots of orders for other people without the markets knowing the full extent actually ensures that everyone gets a better price. Even among the exchanges, however, there is acrimony on this topic. NASDAQ executives have called for a ban on flash-orders even as the NYSE-Euronext ramps up its flash program.

However, many experienced Wall Street observers have offered another, darker explanation. They assert that high-speed trading platforms combined with split-second advance notice can make it very easy for sophisticated players to game the system. They can do this by issuing orders and then quickly canceling them, in order to probe for the maximum or minimum price a seller or buyer would accept for a given share.

Flash orders let them execute these probes nearly instantaneously, so quickly that unsophisticated traders have no idea what happened. Then the HFT masters trade against these same unsuspecting traders to exploit the differential, usually one that is a matter of pennies, between the market price and the maximum that a seller or buyer is willing to accept. (I've personally spoken to traders at large banks who have witnessed this phenomenon underway). Collectively, this allows the HFT practitioners to reap huge profits a little bit at a time, all the while sucking just a bit more money out of the pockets of the slower moving critters on the Street.

Will these practices be banned? That's hard to say. The big banks that are HFT masters -- and uber connected Goldman Sachs is both the biggest and the best at HFT -- are certainly rallying their lobbyists to head off this threat. The SEC, while it has shown a bit more inclination to offend Wall Street than during the previous administration, has yet to undertake any serious enforcement action. But the notable outrage at the recent spate of outsize bonuses paid to Wall Street bankers at the very firms that practice HFT echoing in the chambers of the Capitol Building and down Main Street America is strong tonic for any politician who would prefer to avoid a pitchfork waving populace come election time with unemployment over 10 percent.

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