Here's one big way all this hurts the little guy:
HFT computers can detect large buy orders for a stock, the kind of buy orders mutual funds make, even when the funds try to disguise them. The HTF system can then purchase that stock before the mutual fund's order is executed. The fund ends up paying more per share, and the HTF traders pocket the difference.
This isn't illegal; it's akin to cutting into a long line at the supermarket. And it's just as infuriating. "It just ticks off mutual fund managers who feel their stock moves against them every time they show up," says Al Berkeley, chairman of Pipeline Trading Systems, a trading service designed to help institutions and brokers outsmart HFT systems that try to detect their orders.
How much does all of this cost mutual funds in higher stock prices, or lower prices when they sell? It's not clear, but one study by the Tabb Group estimates that high-frequency traders made about $21 billion in profits last year -- much of that at the expense of mutual funds.
HFT systems have their defenders. If traders can use technology to figure out when mutual funds bumble into the market with a big order, they deserve to profit from it, say analysts at Zero Hedge, a Web site for hard-core finance and investing types. That's another way of saying that mutual funds can fight back with their own technology or pay an outfit like Pipeline Trading to do it for them. "We use the same weapons that high-frequency traders are using, against them," says Berkeley. "We are arms merchants."
But remember: It's fund customers like you and me who will pay the tab.
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2. Flash orders
High-frequency trading sounds even more unfair when it's used with a more controversial high-tech trick, the "flash order" -- the quick display of unfilled trading orders to a select few insiders.Flash orders exist because, over the past few years, upstart stock exchanges like Direct Edge and BATS Exchange have cropped up to do battle with traditional outfits like the New York Stock Exchange and Nasdaq ($COMPX). To win trading volume, the upstarts had to offer big customers something to get their business. Enter the flash order.
Smaller exchanges have to pass along big orders to the big exchanges if it looks like they can't fill them. To avoid this loss, they "flash" these orders to big customers for less than half a second. The hope is that big players will help fill the order, splitting the fees with the small exchange.
But this also gives the insider an advance look at a trading price you and I never see. Mind you, it's a half-second advantage; you and I couldn't do anything with it anyway. But those with HFT systems can.
"The vast majority of the trading world has no way to capitalize on this, absent substantial (capital) investments to the tune of tens of millions of dollars," say analysts at Zero Hedge.
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Here's another thing about flash orders that doesn't seem fair. By pinging most of the market every few milliseconds, a good HFT system can sense overall supply and demand for a stock. When it sees a flash order to buy a stock for which it knows there's limited supply, it'll go out and sop up all the available stock ahead of that order. It can then resell the stock quickly for a profit.
"They know about the order and can beat everyone to the stock because they have a faster system," says one hedge fund manager. "They front-run and drive the price up ahead of everyone else. Anybody buying stock is getting screwed, from the big mutual funds to the smallest guy buying 100 shares."
After The New York Times and The Wall Street Journal broke stories on flash orders and other electronic trading just a few weeks ago, the Securities and Exchange Commission said it would crack down on such orders and investigate related issues. Direct Edge, BATS Exchange -- and the Nasdaq, which has also offered flash orders -- all say they will stop providing them soon.
But given how profitable they are for the biggest traders, we'll have to wait and see how this plays out.
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The firestorm over flash tradingSteve Pearlstein of The Washington Post, CNBC's Bob Pisani and Michelle Caruso-Cabrera discuss whether high-frequency trading is bad for the markets.
3. Dark pools
Technology gives privileged insiders an edge in another way -- by connecting big players inside exclusive electronic trading venues. Because they are private and trading is anonymous, these secretive venues are known as "dark pools."Inside dark pools -- like one called "Sigma X" run by Goldman Sachs and another run by Investment Technology Group -- huge amounts of stock are bought and sold every day at prices that outsiders may know nothing about until well after the fact.
This gives big players two advantages: lower fees on the actual trades and secrecy. When you're making big moves, you don't want competitors to notice what you're doing.
This creates two problems for the rest of us. First, these trades affect the value of stocks you and I own, but they're invisible to those outside the dark-pool set. "They create a very unfair playing field," says Richard Olsen, the chairman of OANDA, a currency trading platform.
Second, if enough trades move to dark pools, they will undermine the significance of publicly available prices on the regular exchanges. That's bad for the economy, because reliable stock prices are supposed to help guide investment dollars to the most deserving entrepreneurs.
In June, more than 7% of all trades happened inside dark pools, according to Rosenblatt Securities. Is that enough to undermine the public markets? The SEC says it's trying to figure that out. But since the SEC is outmatched and outgunned technologically, you have to wonder if it will do any better a job here than it did investigating Bernie Madoff.
Continued: The big meltdown risk
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