Skarbeck: Tactics have proliferated to gain edge in trading

Up until 2007, about 80 percent of stock trading was on the New York Stock Exchange or the NASDAQ. That year, the Securities and Exchange Commission issued Regulation NMS (National Market System), whose noble goal was to increase competition in stock trading, require that brokers execute orders at the best price available, and ensure that all investors have equal access to market data.

Now, in the words of one SEC commissioner, “whether Regulation NMS has achieved its stated purpose, or whether it has produced unintended consequences, is a subject of great debate.” Critics point to a fragmented marketplace with 16 “lit” or publicly registered stock exchanges and about 45 “dark pools” that now compete for stock trades.

The public exchanges publish stock quotes and report the execution of trades for everyone to see. Dark pools are trading venues offered away from public stock exchanges where large institutions can trade anonymously. In a dark pool, a pre-trade price is not visible to any of the participants, and the price of the transaction is disclosed to the buyer and seller only after the trade is done. Institutions are able to minimize the effects of a large transaction by concealing it from other traders who might try to take advantage by buying or selling the stock. But this lack of transparency is what critics argue can lead to less efficient pricing across all stock exchanges.

Another result of Regulation NMS has been the rise of high-frequency trading. HFT uses algorithms to identify trading opportunities that can be executed in nanoseconds and generate profits measured in fractions of a penny. When multiplied by the millions of trades an HFT operator makes on a daily basis, the strategy can be very lucrative. HFT firms argue they are invaluable in providing market liquidity and lowering trading costs.

One HFT firm spent $300 million to build a high-speed fiber network between New York and Chicago to shave three milliseconds off trading times. Other firms pay dearly to locate their computers close to the New York Stock Exchange’s computer servers, giving them a thin advantage to effect transactions ahead of other traders.

Criticism has been aimed at HFT for manipulating trading through “order stuffing,” which involves entering and canceling orders in a blink of an eye. Others consider HFT as “front-running,” as their orders leapfrog ahead of retail customers via high-speed computers. HFTs also have tried to benefit from an informational advantage. Recently, Business Wire, owned by Berkshire Hathaway, announced it no longer would license direct feeds of its news releases to HFT firms.

Over the next year, the SEC is going to analyze and re-examine the current stock market trading structure, which likely will result in significant rule changes. In response, HFT firms are forming an organization called the Modern Markets Initiative that will undoubtedly lobby against reforms that would eat into their profits.

A few pennies lost on a buy or sell transaction matters little to a long-term investor who instead is focused on the fundamentals of the companies he owns and their strategy to grow shareholder value. Yet the core issue here is market integrity, and all participants should feel they are getting a fair shake when they place a stock order.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.