Speed-addicted traders dominate today's stock market

The cramped computer room in an office building overlooking the Harbor Freeway can't match the color and tradition of the New York Stock Exchange.

No traders, opening bell or operatic din. Just floor-to-ceiling racks of Dell and Hewlett-Packard computers spitting out a monotonous drone. The only people passing through are janitors and the occasional programmer or electrician.

But while the NYSE remains the cynosure of the global markets, much of the world's stock trading emanates from drab computer rooms such as this one in downtown Los Angeles, or in outposts such as Kansas City, Mo., or Jersey City, N.J.

These are the epicenters of high-frequency trading, a breed of lightning-fast computerized trading that dominates today's stock market, but which critics say carries risks for investors and for the market itself.

Regulators have yet to pinpoint the cause of Wall Street's white-knuckle plunge May 6, when the Dow Jones industrial average sank 700 points in less than five minutes. High-frequency trading isn't believed to have sparked the sell-off but may have contributed to it.

To critics, that's evidence of the threat they say is posed by high-speed trading.

Detractors argue that high-frequency firms gain an edge through predatory trading tactics that harm other investors. Worse, they say, split-second trading has the potential to destabilize the market at turbulent moments. Given the speed and huge sums involved, one errant trade could wreak havoc, critics say.

"They're destroying the market from which they're making so much money," said Joe Saluzzi of Themis Trading in Chatham, N.J. "They're like locusts. They come in, swarm the market, squeeze as much as they can, and when they're done they'll just move on to a new market."

The high-speed industry dismisses such criticism. They say they've made trading cheaper and more efficient for all investors, and claim they're being made scapegoats for the perceived transgressions of others on Wall Street.

"Everybody wants to blame high-frequency trading for any sort of malice that's occurring on Wall Street," said Manoj Narang, chief executive of Tradeworx Inc., a Red Bank, N.J., investment firm that does high-frequency trading. "It's a ridiculous blame game."

The rise of high-frequency trading is the culmination of more than three decades of automation on Wall Street, which has seen a host of upstart electronic trading networks chip away steadily at the hidebound NYSE, with its stately Corinthian columns, famed bell ringing and bellowing human traders.

Beginning in the early 1970s with the creation of Nasdaq, an all-electronic marketplace composed of big brokerage firms, these networks were able to execute trades faster and more cheaply than the NYSE.

The Big Board responded by installing its own technology; floor traders were issued hand-held devices that replaced the wild gesticulating of earlier generations. It also bought a big electronic competitor.

But ever more sophisticated software, coupled with new government rules to cut investor trading costs and speed up the market, spawned a fresh generation of high-speed traders and new all-electronic stock exchanges catering to them.

Though just a few years old, two new exchanges, Direct Edge in Jersey City and BATS Global Markets in Kansas City, each have seized about 10% of U.S. trading volume. The NYSE's share of trading in its own listed stocks, by comparison, has slumped to 34% from 76% four years ago, according to Equity Research Desk in Greenwich, Conn.

In a bow to its faster brethren, the NYSE is building a high-speed trading hub in suburban New Jersey. It also recently signed a high-speed trading firm to operate on its tradition-steeped floor.

Firms that engage in high-speed trading, such as Tradebot Systems and Getco, account for an estimated 60% to 70% of U.S. trading volume, and their market share is on the rise.

"They're the man behind the curtain of the market," said Jamie Selway, managing director at New York brokerage firm White Cap Trading.

The high-frequency game is all about speed. The goal is to be the first to buy or sell at the most advantageous moments. Shares are swapped in millionths of a second, and being even a microsecond late can be the difference between snagging a trade and losing it to the next guy.

High-frequency traders' often-tiny gains on those trades added up to $7 billion last year, Tabb Group, a research firm, estimates.

Traders toast their successes at bimonthly happy hours in New York bars. They'll converge next month at Johnny Utah's, a cavernous watering hole near Rockefeller Center that features a 300-pound mechanical bull.

Hedge funds and brokerage firms pour millions of dollars into developing trading software, and guard it zealously. Goldman Sachs Group turned to the FBI last year when it suspected a former employee of stealing sensitive computer code. FBI agents arrested the man after he got off an airplane in New Jersey. Other firms have sued departing employees.

Some analysts say automated trading is good for the market.

By virtue of the millions of orders they place each day, high-frequency firms make it easier for investors to complete trades quickly at fair prices. When a small investor buys or sells shares, there's often a high-speed trader on the other end.

Critics contend that high-speed traders have unfair advantages over other investors that could potentially destabilize the market.

Federal regulators have proposed rules to crack down on some practices.

The Securities and Exchange Commission is seeking to ban so-called flash trading, which critics say allows high-speed outfits to get an early glimpse of orders from other investors before they're accessible to the entire market. That yields enormous clues about the short-term direction of certain stocks, enabling traders to position themselves before the tidal wave of other orders hits.

High-frequency traders acknowledge their edge in deciphering trading patterns. But they say it's because they've built a better mousetrap, not because the system is gamed in their favor.

"If some people are better at analyzing data than other people," Narang of Tradeworx said, "I don't think anybody has a problem with that."

The SEC also wants to ban "naked access," in which brokerage firms allow the high-speed crowd to send orders directly to the market without first passing through the broker's traditional pre-trade checks and balances.

The review process ensures, for example, that a trader doesn't put through an inadvertent sell order that capsizes the market. The check takes only a split second, but naked access proponents say that's enough for them to miss a trade.

Some regulators aren't sympathetic.

"Unfiltered access is similar to giving your car keys to a friend who doesn't have a license and letting him drive unaccompanied," SEC Chairwoman Mary Schapiro said in proposing the rule.

Defenders say a variety of other checks already are in place to preempt a disastrous trade.

"Naked access is not harming the market," said Jeff Bell, an executive at Los Angeles brokerage Wedbush Morgan Securities Inc., a naked access provider. "Our firms and our clients are among the most sophisticated technologists and traders, and have built a process that is absolutely solid."

Naked access services account for roughly 9% of Webush's overall revenue, Bell said. Most of Wedbush's naked-access clients are other brokerage firms that already have performed their own checks, he said.

That's little comfort to Benn Steil, who follows financial issues at the Council on Foreign Relations.

"Naked access is problematic," Steil said. "All you need is one time for something to go wrong."

A more pressing problem, some experts said, is the underlying structure of the market.

An unintended byproduct of the SEC's move to encourage electronic trading has been a weakening of the NYSE specialists and Nasdaq market makers that traditionally maintained orderly trading. They were required to step in and buy during heavy sell-offs, thus limiting the magnitude of free falls.

Their role has diminished as their profits have shrunk, experts said. That's because high-speed traders fill many of the orders once handled by traditional firms. But unlike specialists and market makers, high-frequency players can choose not to trade during turbulent moments, such as when the Dow plummeted May 6. Experts say that may be a big reason stocks fell so hard so fast that day: There was no one to step in and buy.

"Over $1 trillion of market value evaporates in less than 15 minutes and people say, 'Who is to blame?' " Themis Trading's Saluzzi said. "No one is to blame. This is the market that we have. This is the byproduct of a market structure that has gone horribly wrong."

The SEC and other regulators are mulling over various changes in the aftermath of the market plunge. But few believe they'll crimp high-frequency trading.

"It's not bad or evil," Wedbush Morgan's Bell said. "It's technology innovation. You can't slow it down."

walter.hamilton@latimes.com

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