Financial Regulatory Forum

ANALYSIS-SEC panel pits wider debate over automated trading

By Reuters Staff
June 22, 2010

By Herbert Lash

NEW YORK, June 22 (Reuters) – U.S. security regulators have billed a panel they host on Tuesday as a talk about liquidity, yet really at issue are the fading ideals of long-term investing and the brave new world of rapid, automated trading.

The Securities and Exchange Commission has brought together some of the biggest practitioners of “high frequency trading” — Tradebot Systems and Jump Trading LLC — and a flag bearer of deep value investing, Southeastern Asset Management Inc.

The title of the discussion, a “perspective on liquidity,” is apt considering the SEC and the Commodity Futures Trading Commission have identified a breakdown in liquidity as one of the likely causes of the still unexplained May 6 flash crash.

Yet for many in the market, in particular investors known as the buy side, more is at stake than arguing over whether automated trading has made markets more efficient and reduced trading costs, a view that the fast traders tout.

How high-frequency trading, which now dominates U.S. equity markets and is spreading to other asset classes, will impact investing should be more thoroughly explored, they say.

For these investors, rapid trading is just the latest step in a trend of markets becoming more speculative and akin to commodity pits.

“Our psychology has fallen victim to a notion that, without qualification, technology and speed should be embraced,” said Jeff Engelberg, senior trader at Southeastern in prepared remarks to the SEC.

“Contrary to the claim that speed reduces risk, the introduction of excessive speed and unrestrained technology destabilized the markets and made them wholly indecipherable on May 6,” he said.

Detractors such as Southeastern say the stock markets have become little more than casinos and rapid, automated trading has crippled the formation of capital, a key function of markets that could cause long-term harm to the U.S. economy.

“The thing that’s pretty obvious is the high-frequency traders have taken the legitimate function of capitalism — fund-raising, investing — and turned it into a casino, turned it into gambling,” said George Schwartz, president of Schwartz Investment Counsel Inc., manager of the Ave Maria Funds, in Bloomfield Hills, Michigan.

“It’s got no semblance of capital raising as it relates to capitalism and prudent long-term investing,” said Schwartz, who has been active on Wall Street for more than four decades. “That is what is obvious too most people even if they don’t understand the intricacies of the computer-driven trades.”

The detractors of high-frequency trading also argue that unlike their frequent claim of providing liquidity to the markets, they in fact only provide ample trade in the large-cap stocks that make up the Standard & Poor’s 500 Index.

David Weild, another scheduled participant in the panel, has done several studies for Grant Thornton that indicate liquidity in small-cap stocks has dried up and hurt the market for initial public offerings for sales under $400 million.

The SEC in its concept release on equity market structure in January voiced concern about trading in small-cap stocks.

As Schwartz acknowledged, many investors do not fully understand how rapid, automated trading works. That lack of understanding is the cause of unwarranted angst among many investors, defenders of rapid trading say.

“Many of these short-term investors don’t strike me as rabid speculators. They’re not drooling day traders going ‘Ooh I’m listening to emanations from the planet Mars,’” said James Angel, a finance professor at Georgetown University who has studied high-frequency trading.

Cameron Smith, general counsel at Quantlab Financial LLC, a Houston firm that does high-frequency trading, said the increase in trading volume and improved quality of execution should belie any doubts about liquidity in the markets.

As for May 6, Smith said the Chicago Mercantile Exchange, which is highly automated with many high-frequency traders, functioned smoothly, in contrast to some stock trading.

“You do need some timeouts, hopefully very short, that allow liquidity to flow back into the market,” Smith said. “One had a circuit breaker for five seconds, the other one had nothing. A big divergence in terms of the ability to handle the big move.”

(Reporting by Herbert Lash; Editing by Andrew Hay) ((herb.lash@thomsonreuters.com; +1 646 223 6019; Reuters Messaging:

herb.lash.reuters.com@reuters.net))

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