Fisher Investments Editorial Staff
Media Hype/Myths

Attack of the Machines!

By, 08/06/2009

Story Highlights:

  • The SEC is deliberating over the electronic trading tools known as "flash orders" and dark pools—used by institutions but largely closed off to individual investors.
  • Critics argue these trading technologies give a small segment of the investing universe an advantage over "everyday" investors and create fragmented markets.
  • Advocates say high-frequency trading increases market liquidity, makes order execution more efficient, aids price discovery, and provides more opportunities for other investors to buy and sell.
  • The SEC will likely formally issue proposals regarding flash orders and dark pools in the coming weeks—investors should keep an eye on this.

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Mysterious forces. Market manipulation. A technological arms race! Are ordinary investors under attack from supercomputers? The SEC seems to think so, as it deliberates over the electronic trading tools known as "flash orders" and dark pools—used by institutions but largely closed off to individual investors.

There's a lot of hype—and misunderstanding—about these trading techniques. Electronic trading has been around for decades. As computer speed and processing abilities advanced and competition for market share among exchanges increased, electronic trading became more sophisticated and innovative. Today, powerful computers allow traders to complete millions of orders in mere milliseconds using myriad algorithms, in what's commonly referred to as "high-frequency trading."

One high-frequency trading practice—flash orders—is leading to cries of front-running, though most major exchanges today use the flash trade system. For a fee, the exchanges allow clients a very brief look (30 milliseconds—or 0.03 seconds) at orders before they're routed to the market. Though just a brief "flash" of time, lightning-fast computers can pick up on the order and automatically buy and sell the shares to reap a profit—maybe to the original order-placer's disadvantage. The SEC is currently looking into the "inequity that results from flash orders."

The SEC is also examining rules governing dark pools. These are electronic-trading networks that allow institutions to post buy and sell orders anonymously and out of the public eye. Though ominous sounding, dark pools have allowed institutions to execute large transactions with minimal information leakage and minimal price impact.

Critics of high-frequency trading (flash orders in particular) and dark pools argue these practices give a small segment of the investing universe a technological advantage over "everyday" investors and create fragmented markets. Advocates say high-frequency trading—which accounts for over half of all US stock trading—increases market liquidity, makes order execution more efficient, aids price discovery, and provides more opportunities for other investors to buy and sell.

Perhaps high-frequency trading does give select investors an edge, but does it harm the rest? If it does, probably not by much. Though high-speed, automated trading algorithms are more sophisticated and widely used today, there are enough different strategies that the potential for market manipulation is limited. Flash orders, for example, only accounted for 2.4% of all US stock trading in June. Further, some of these algorithms are very bland while others seek very tiny arbitrage opportunities—and of course, not all algo-trading strategies are successful.

The idea of dangerous super-machines taking advantage of humans is the stuff of sci-fi, not markets. High-frequency trading will no doubt be here to stay, though the SEC will likely formally issue proposals in the coming weeks regarding flash orders and dark pools. A ban on flash orders is probable, but this move likely won't impact markets or trading much.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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