How Regulations Led to High-Frequency Trading
The great irony of the report on the costs to regular investors of high frequency trading is that high frequency trading is largely a product of regulation.
The usual story about the fall of the market-making specialists who once crowded the floors of stock exchanges is told in terms of technological progress. The specialists play the role of the buggy-maker in the age of the automobile, an archaic business that just was bound to vanish.
But that's not really what happened. The specialists were not brought down by the Rise of the Machines. Rather, the fall of the specialists—at the hands of regulators—triggered the Machine Uprising.
High frequency trading grew up in the aftermath of a decades-long struggle by Congress, the SEC, and the stock exchanges to stamp out the specialists, who were accused of front-running customers, favoritism and interfering with the smooth operations of markets. You can read a great time-line on this struggle from Bob Pisani here.
Things really came to a head after the dot-com crash, when everyone was looking for someone to blame for all that money lost. By 2005, the government passed a series of market reforms that were aimed directly at eliminating the specialists. In the wake of those reforms, commissions fell, pricing improved, exchanges became more competitive—and high-frequency trading arose.
We now know, at least in the futures market analyzed by the report, that high-frequency traders extract their profits from other market actors and that retail investors get the worst of it. We traded one group suspected of exploiting their market position to harm retail investors for another group that does that anyway.
Not one person forecast that the result of the squeeze on specialists would be high-frequency trading. So one general lesson we should take from this is that we are unlikely to be able to anticipate the consequences of regulatory intervention in market practices.
Another lesson, however, may be that financial markets require insiders who gain at the expense of outsiders. The insiders may provide some critical function and need to be able to charge outsiders for the performance of this function. This suggests that further attempts to regulate away the exploitation of retail investors will just give rise to a new class of exploiters.