Wall Street on Speed

The New York Times recently reported that the latest
scheme--or scam--on Wall Street is something called High Frequency
Trading. Very sophisticated financial firms, such as Goldman Sachs, are
tipped off by the New York Stock Exchange's own computers to pending
buy and sell orders. Armed with ultra sophisticated computer
algorithms, the insiders anticipate the direction of the market based
on what they learn about supply and demand for a given security. They
can make an extra penny here and an extra penny there at the expense of
us suckers, adding up to billions.

"Nearly everyone on Wall Street is wondering how hedge funds and
large banks like Goldman Sachs are making so much money so soon after
the financial system nearly collapsed," wrote the Times' Charles Duhigg in a front page piece that was the talk of New York and Washington. "High-frequency trading is one answer."

As debates in the blogosphere in the last couple of days have made
clear, there are a couple of possibilities of what is at work here. One
is that Goldman and others are literally using privileged information
to make trades ahead of markets, in which case they are committing a
felony. Specifically, the abuse is known as "front-running," or trading
ahead of customers, and it is an explicitly illegal form of market
manipulation. Front running is epidemic on Wall Street--the whole point
of an investment bank trading for its own account is to take advantage
of its specialized knowledge of markets--and the SEC or the Justice
Department shuts down front-running when it becomes too blatant to
ignore.

The other possibility is that the Goldmans of the world have found
themselves a nice loophole. Tapping into the Stock Exchange's own
computers and other sources of trading activity is something that
anyone in theory could do, but only a few privileged insiders have the
sophistication to exploit what they find. Often orders are placed, only
to be cancelled. Their purpose is to figure out what the market is
willing to pay, and then get in ahead of it.

But suppose that High Frequency Trading doesn't violate any law. It
still is the essence of what's wrong with the recent metastasis of
money markets into private game preserves for insider-traders.

Consider for a moment some first principles. The legitimate and
efficient function of financial markets is to connect investors to
entrepreneurs, and depositors to borrowers. There is no legitimate
reason whatever for this to be done by the millisecond. At bottom, the
process is pretty simple. The intermediary--the bank, savings
institution, or investment bank makes its fees for making a judgment
about risk and reward. How likely is the loan to be paid back? How high
an interest rate should it charge? How should a new issue of securities
be priced? The investor decides whether to indulge a taste for risk or
for prudence.

But the hyperactive trading markets and creations of recent decades
such as credit default swaps and high speed trading algorithms add
nothing to the efficiency of financial markets. They add only two
things--risk to the system, and the opportunity for insiders to reap
windfall profits.

Therefore, whether or not Goldman's lawyers have figured out how it
can engage in High Frequency Trading and stay within the law, there is
a strong case that this entire brand of financial engineering should be
prohibited. The whole game should be slowed down. Bona fide investors
should get in line under the rule of first come, first served. Anything
else should be considered illegal market manipulation. No dummy
transactions. There is absolutely no gain to economic efficiency from
having prices of securities change in milliseconds, and much gain to
the opportunities for manipulation.

The need to restrain traders from exploiting their privileged
knowledge is an old fight. During the New Deal, for example, many
reformers proposed that floor specialists for investment bankers and
brokerage houses simply be prohibited from trading for their own
accounts. They should be there simply to execute buy and sell orders
for customers. Otherwise, the conflict of interest would be
overwhelming--and this was before computers. These reformers were
overruled, but insider trading was explicitly prohibited (and good luck
catching it.)

Now, as then, it is a mark of Wall Street's stranglehold on politics
that the most sensible of remedies seem impossibly radical. One very
good way to damp down the dictatorship of the traders, and raise some
needed revenue along the way, would be through a punitively high
transactions tax on very short term trades. Genuine investors should
get favored fax treatment. Pure traders should be taxed, and very short
term manipulation taxed into oblivion.

If the financial crisis has proven anything, it is that capital
markets have become an insiders' game in which trading profits crowd
out the legitimate business of investment. The whole business-models of
the most lucrative firms on Wall Street are a menace to the rest of the
economy. Until the Obama administration recognizes this most basic
abuse and shuts it down, it will be more enabler than reformer