The politics high-frequency trading

July 25, 2009

Love blogging. The link suggested by Martha about the high-frequency trading debate prompted a thousand thoughts among NYTimes readers. Looking over the readers’ comments (see link), it is clear that this may reopen a number of issues that the Bush-controlled SEC hoped to seal off for good. Here’s the link. Scroll down for the comments.

So, what issues? Specifically, the accusation that the system is rigged against retail investors — in favor of large players. Traditionally, the NYSE did have the obligation to level the playing field… but the exchange grew huge and lucrative in the process. The introduction of Reg-NMS de-emphasized this social goal, in favor letting faster, smaller exchanges that competed with the NYSE. These exchanges grew dramatically. What we see now, however, is that large players –Goldman, hedge funds– might have reaped a disproportionate share of those gains from competition. They not only owned some of the exchanges, but also had the high-frequency trading desks that could exploit the new velocity.

What to make of it? One is to conclude that exchanges pose a governance dilemma. This intriguing argument was made to me by Frank Hathaway, Chief Economist of the Nasdaq. It’s a beautiful theoretical point. Market exchange is typically presented in organization theory (say, Williamson) as the opposite of hierarchical coordination. But the fact is that exchange itself needs to be organized. And this organization poses the challenge of abuse of power. Whoever gets to rule exchange (large banks, exchange employees, shareholders) tends to benefit inordinately at the expense of the other stakeholders.

What to do about it? One way out of this dilemma is to have an ecology of exchanges with different governance forms… bank-owned, specialist-owned, and shareholder-owned … that compete with themselves. This just happened two weeks ago in the case of treasure futures. The introduction of the bank-sponsored Electronic Liquidity Exchange (ELX) introduced competition against the Chicago incumbent, heavyweight CME. The CEO of the ELX, Neal Wolkoff, recently addressed my class in Columbia and shared with us the thrill of bringing new alternative to the market. His challenge, though, is that his own ship is the property of the large Wall Street banks. Will they push for a utility-like low cost exchange, or let Wolkoff innovate and expand into new asset classes?

Which brings us back to the NYSE and the New York Times article. In the equities space, there’s a simple way to cultivate the “ecology of governance forms.” Loosen up the regulations that limit what specialists and floor brokers can do at the NYSE — so that their form of trading can survive. Speaking with ex-specialists at the Exchange, it was fascinating for me to see the daring designs they have for their floor once those restrictions are eliminated.

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