While caught like a deer in the headlights when the costs of high-frequency trading first came to light, the SEC is finally beginning to flex some muscle on behalf of the investing public it is charged with representing.
To paraphrase one of my earlier columns on the subject, the Michael Lewis book "Flash Boys" explains the phenomenon that costs us small investors so much money. The emergence of new electronic stock markets beyond the familiar New York, American and Nasdaq exchanges has created over 30 new computerized exchanges that trade stocks in milliseconds. And these trades make up the vast majority of all stock trading today. The advantage for those who practice high-frequency-trading (HFT) is the ability to trade ahead of the major institutions, such as mutual funds, that service the rest of us. Our money managers find that they are frustrated in attempts to buy and sell large blocks of stock cost effectively because HFT contaminates the pricing. It costs our managers more to buy, and they get to sell for less, than would have been the case more than five years ago before this phenomenon reached full flower.
An estimate of what this type of trading makes overall is somewhere in the neighborhood of $22 billion per year, which would mean about one quarter of 1 percent of the total $17 trillion in U.S. equity assets. That doesn't sound like much until some second-grade arithmetic determines who's paying that money and how small investors might be contributing far more than just one quarter of a percent.
Here is why. Of the $17 trillion, much of the money is in stocks that rarely trade or that are in index funds with only 6 percent annual turnover. Actively managed mutual funds, which are major components in 401(k) and IRA accounts, typically have over half of their securities exchanged for others in a typical year. As a percent of the $17 trillion, this is a relatively small portion but which, all by itself, contributes to that 0.25 percent of the total. So we could be paying one full percent or more. In one publicized case, a high-frequency trader makes the claim that they never have a day in which they lose money. Meanwhile, nine major too-big-to-fail banks operate highly profitable "dark pools" and are the enablers of 70 percent of the high-frequency trading. For allowing this access, they are paid hundreds of millions of dollars per year.
Why our elected representatives and regulatory authorities allow this to happen is answered by the fact that over 200 staffers of the Securities and Exchange Commission since 2007 have left to go to work for high-frequency trading firms.
But the tide may be turning despite this unfavorable tilt in the playing field. Dark pools operated by Barclays and Credit Suisse recently generated fines totaling $153 million. In these cases, the organizations assured investors that the exchanges they operated were insulated from high-frequency trading -- and then they went ahead and allowed it anyway. Payments from the HFT crowd were just too huge to pass up.
Meanwhile, the violators of security laws admitted to wrongdoing, but were granted waivers to maintain their status as so-called "well-known seasoned investors." Whatever happened to the days when thieves would be barred from the securities industry for life? Who from these companies is going to jail for defrauding their customers, and who in top management knew what was going on? Since when is about $153 million any kind of a deterrent to companies that make several billion dollars a quarter? Whatever happened to the concept of punitive damages that turns a small settlement into an expensive message that it will cost companies a lot to repeat the mistake? Damages of $1.5 billion would have been a shot across the bow of other companies otherwise tempted by the same practice.
It wasn't that long ago when Arthur Anderson, one of the nation's "Big Five" CPA firms with over 10,000 employees was put out of business in the wake of what a few people did to support the collapse of Enron. A witness for the government who was being harassed in court by the Enron lawyer had to remind the latter he was addressing a spokesman for "the people of the United States of America." It was a great reminder of what government power, properly applied, can accomplish on our behalf.
So, as high-frequency trading continues to reduce the earnings of small investors, when should we demand that the SEC force perpetrators to abandon that business, if not, shut down completely in the case of outright fraud? In the next similar instance, it would be gratifying to see TV news depicting the scene whereby all the firm's employees come streaming out of the building carrying their personal belongings in cardboard boxes. Unfortunately, if we "scrap" Dodd-Frank regulations and reduce SEC funding as some politicians suggest, it won't happen any time soon.