The Dust Hasn't Settled on Wall Street, but History's Already Repeating Itself

By Steven Pearlstein
Friday, July 31, 2009

The Wall Street herd is at it again.

Even as the cleanup crew is carting away the debris left by the last financial crisis, the investment banks, hedge funds and exchanges are busy working on the next one.

Forget collateralized-debt obligations and credit default swaps -- the new new thing is high-frequency trading. In the last three years, this practice has boosted trading on the country's stock exchanges by more than 150 percent, to the point where it now accounts for two-thirds of the daily trading volume.

With high-frequency trading, high-speed computers, programmed with proprietary software based on complex algorithms, spew out a constant stream of orders to buy and sell millions of shares of stocks and other securities, hoping to make a penny on each trade. Although high-frequency traders employ any number of different strategies, what's common to virtually all of them is that shares are usually held for only minutes or even seconds.

Because it thrives on volatility, high-frequency trading has generated hefty profits over the past two years for hedge funds and proprietary trading desks, and hefty bonuses for the quants who oversee it. It has also generated lots of fees for the exchanges and brokers who process the trades and are now locked in a high-tech arms race to see who can install the biggest, fastest computers to execute them. This has even generated a caper worthy of a David Ignatius spy novel: federal officials recently charged a former Goldman Sachs executive with stealing the firm's closely guarded high-frequency trading software on his way out the door.

There's nothing radically new about any of this. Program trading executed by computers at automated exchanges has been around for decades and can be done by day traders sitting at home using an E-trade account. What's different now is the speed, the sophistication of the algorithms and the volume of trading. For Wall Street, it is simply the latest technological innovation to increase the liquidity of the markets, improve transparency and dramatically reduce the cost of executing trades.

If that sounds familiar, it is -- those are the same justifications we heard for portfolio insurance, which prompted the 1987 stock market crash, and for the derivatives trading, securitization and naked short-selling that led to our recent crisis. Though it is undeniable that all of these much-ballyhooed innovations have made markets more efficient, there's good reason to suspect they also make markets more volatile, less stable and less fair.

Already, the Securities and Exchange Commission is preparing to clamp down on exchanges that, in return for special fees or guaranteed trading volume, provide certain hedge funds with access to some trading orders that come into its computers a fraction of a second before they are "posted" for everyone else. That's just enough time for the hedge funds' computers to detect patterns in the order flow and use that insight to trade ahead of other market participants.

There is also concern that hedge funds may be using their access to the high-speed trading systems of the exchanges or licensed broker-dealers to manipulate markets to their advantage. The SEC's staff is considering whether to impose reporting requirements on funds that have direct access to these high-speed trading platforms or locate their own computers alongside them.

That's all well and good, but it sounds like the sort of narrow fixes preferred by SEC lawyers who haven't spent much time on Wall Street. Maybe the better question is whether we could have a robust economy without innovations such as high-frequency trading that allocate much of the rewards to Wall Street and the risks to everyone else.

Yes, it's surely a good thing that newly competitive stock exchanges are using the latest technology to process larger volumes of trades more quickly and more efficiently. And there's nothing wrong with hedge funds and other traders using sophisticated software to devise and execute dynamic trading strategies.

But as far as I can tell, buying and selling huge volumes of securities in a matter of seconds is just another high-tech form of speculation that is only remotely connected to the fundamental purpose of financial markets, which is to raise and allocate capital efficiently for businesses that need it. Liquidity is certainly good for markets, but we recently learned from painful experience that it is also possible to have too much of it. And though sophisticated computer systems can be powerful tools in plotting trading strategies and managing risk, we also know that these systems have blind spots and can backfire when too many people try to pursue the same strategy at the same time.

There are those on Wall Street who look at every innovation and ask, Why not? I look at much of what they've dreamed up and ask, Why?

Steven Pearlstein can be reached at

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