WSJ: High-Frequency Trading Needs One Quick Fix

http://online.wsj.com/articles/andy-kessler-high-frequency-trading-needs-one-quick-fix-1402869253

In the "state your conclusion upfront department," the Senate Permanent Subcommittee on Investigations has scheduled a hearing for June 17 titled "Conflicts of Interest, Investor Loss of Confidence, and High Speed Trading in U.S. Stock Markets." They join the Securities and Exchange Commission, the FBI, the Justice Department, the Commodity Futures Trading Commission and, inevitably, Eric Schneiderman in uncovering what the New York attorney general calls "this new breed of predatory behavior."

Too bad none of the investigations will figure out that changing one word in a federal regulation can fix all this. Because none of them understands the old Wall Street adage: "On Wall Street, everybody gets paid."

Follow the money: In an initial public offering, the investment bankers get 7% underwriting fees, and the funds buying the newly issued shares get a 10%-15% first day trading pop. Mutual funds holding the stock charge 1%-2% annual fees, and hedge funds keep 20% of their upside. Stockbrokers sometimes collect commissions, though that's tougher in the days of $8.95 trades from discount brokers. And yes, stock traders need to get paid too.

Being a New York Stock Exchange specialist—each stock had one—was a lucrative business because there is information in every trade. Like Nasdaq market makers, they didn't charge commissions but instead would keep the spread, or the difference between the bid and the ask price, measured in quarters (25 cents) and eighths (12.5 cents). And specialists were notorious for front running customers. Simply put, if they didn't like the spread on a buy order, they would buy shares themselves and then raise the price of the shares they had to offer, knowing there was a buyer in the market. At a cocktail party many years ago, I asked a specialist about this and he told me, "You big investment banking guys shouldn't worry about it, we need to get paid too."

Adding insult to injury, spreads shrank to almost nothing after decimalization started on April 9, 2001. Even spreads of 1/16th or 6.025 cents were too large and we quickly moved to a penny. Trust me, it's hard to get paid trading for a penny spread.

Electronic trading was considered more efficient and even more honest. So in 2005 the SEC's Regulation National Market System or Reg NMS began encouraging it. At the same time, Wall Street firms stopped putting up their own capital or liquidity to facilitate trades because they couldn't get paid enough to bother. Over time they created their own electronic trading venues known as dark pools, to try to match customer buy and sell orders, but with little success until they let high-frequency trading into the pool.