[ Editor's Note : During the last nine months, Money Morning has repeatedly warned readers that so-called 'high-frequency trading,' or HFT, was trouble waiting to happen for U.S. investors. On Thursday, events proved us right. Experts say HFT was responsible for a plunge that sent the Dow Jones Industrial Average down nearly 1,000 points late in the trading day.]

Back on April 14, U.S. stocks advanced for the fifth day in a row, causing the U.S. Standard & Poor's 500 Index to close above the 1,200 level for the first time in more than 18 months.

Traders said that a growing confidence in the strength of the U.S. rebound was a key rally catalyst.

But Money Morning's Shah Gilani was worried.

In fact, in a column published in Money Morning the next day, the retired hedge-fund manager and Money Morning contributing editor warned that traders were overlooking a key point. According to Gilani, so-called "high-frequency trading" was responsible for much of the stock-market volume that investors have been seeing of late – meaning "real" volume was actually much lower.

The bottom line: Gilani believed that U.S. stocks were highly vulnerable to a deep downdraft.

That vulnerability introduced itself to investors in a big way on Thursday, playing a huge role in a whipsaw-trading day that sent the Dow Jones Industrial Average screaming into a near-1,000-point nosedive at one point late in the day.

"I warned that high-frequency traders (HFT) were responsible for too much of the volume we've been seeing. I noted that, if they exited (turned their program-driven automated trading systems) the market, liquidity would dry up and exacerbate any downdraft," Gilani said in an interview today (Friday). "I also warned that HFT – by the very nature of the complexities of how it works, could misfire and muck up some or all of the major exchanges. Guess what: That's exactly what happened to cause the big spike down yesterday."

Anatomy of a Downdraft

The U.S. stock market went on a wild ride Thursday, with the Dow Jones Industrial Average plunging nearly 1,000 points late in the afternoon. That plunge sent the Dow down to 9,869.62 at about 2:40 p.m. EDT – its first time below the 10,000 level since November 2009.

The Dow retraced some of its steps and ended up closing at 10,517 – down 350.97 points, or 3.2 % on the day. The Nasdaq Composite Index closed at 2,319, down 82.65 points, or 3.4%, and the Standard & Poor's 500 Index closed at 1,127, down 37.85 points, or 3.2%.

The Dow lost another 141 points today (Friday), to close at 10,379.60. For the week, the Dow dropped 772 points, or 5.7%, its worst one-week showing since October 2008.

The downdraft started because of concerns that the Greek debt situation was making the leap from crisis to contagion, and might be infecting the finances of other European countries.

But stocks soon were down much more than was warranted by the now-well-known crisis among the "PIGS" (Portugal, Ireland (and/or Italy), Greece and Spain) in euro land.

Just before 3 p.m. Thursday, the Dow was down bout 180 points.

Then the index literally fell right off a cliff. It dropped more than 900 points, then retraced its steps by several hundred points – in a mere 20 minutes. Volume skyrocketed to its highest levels in more than a year, and some stocks underwent a nightmarish plunge.

According to a Newsweek.com report, shares of Accenture PLC (NYSE: ACN) dived from $41 all the way down to a penny a share, and then back to $35 – in a less than five minutes.

Shares of The Proctor & Gamble Co. (NYSE: PG) crashed from about $60 down to $48 – only to then zoom up past the $60 level, again in just a few minutes. That's more than can be logically explained by today's news that the Consumer Product Safety Commission is investigating reports of severe rashes caused by two new lines of Pampers diapers – which are made by P&G.

In the postmortems that started Thursday night, HFT is being identified as the chief suspect behind the near tragedy. Computer-driven trading algorithms now account for nearly 70% of all U.S. stock market volume.

A Chicago-based market observer and HFT expert told Newsweek that rumors are circling about a computer glitch hitting one of the automated trading systems operated by a Citigroup Inc. (NYSE: C) unit. The system is said to have essentially gone "haywire."

"This is why quality control is so essential on these automated systems," the market observer, who asked to remain anonymous, told Newsweek.

Other rumors – including the story of the now-fabled "fat-finger discount" – are making the rounds, too. In this particular rumor, human error is said to have been the culprit. In this scenario, a trader or trader's assistant allegedly typed "billion" instead of "million" into a sell order.

"When you tell a computer to do something – no matter how irrational – it doesn't ask: 'Are you sure?' It doesn't say: 'That's insane.' It simply executes the order," the Newsweek account states.

An Earlier Warning

Gilani's warning about the perils of high-frequency trading wasn't the only time Money Morning has cautioned readers about the potential pitfalls of this high-tech trading strategy.

Back in mid-August, Money Morning's Martin Hutchinson, a former U.K. and U.S. merchant banker, characterized HFT as "Wall Street's new rent-seeking trick."

"When the U.S. economy is facing collapse and merger and acquisition volume is way down, it seems odd that investment banks like Goldman had record quarters," Hutchinson said. "Well, here's the secret: [Wall Street investment banks] have found a new way to skim more of the cream off the top of U.S. economic activity. It's called "High-Frequency Trading."

According to the Newsweek report, institutional traders "load complex trading algorithms into supercomputers, hook them up to stock exchanges, and then trade vast amounts of stocks at warp speeds, literally millions of shares in a matter of milliseconds. With each trade, the codes gobble up about one tenth of a penny. Eventually, a few billion pennies add up to serious money."

That gives institutions a massive – even insurmountable – advantage over other investors, experts such as Money Morning's Hutchinson says.

"HFT computer servers are able to beat other computers because they are located at the exchanges. They take crucial advantage of the finite speed of light and switching systems to front-run the market," he explained. "They also gain information on orders and market movements more quickly than the market as a whole. They operate not only on the New York Stock Exchange (NYSE), but also on the electronic trading exchanges such as the NYSE hybrid market."

Hutchinson described the cast of characters that make up the population of high-frequency traders. They include:

The "liquidity-rebate traders," who take advantage of volume rebates of about 0.25 cents per share offered by exchanges to brokers who post orders, which is supposed to provide liquidity to the market. When they spot a large order they fill parts of it, then re-offer the shares at the same price, collecting the exchange fee for providing liquidity to the market.

The "predatory-algorithmic traders" – also known as "predatory-algo players," who take advantage of the institutional computers that chop up large orders into many small ones. They go to the institutional trader who wants to buy and make him bid up the price of shares by fooling its computer, placing small buy orders that they withdraw. Eventually the "predatory-algo" shorts the stock at the higher price it has reached, making the institution pay up for its shares.

The "automated-market makers," who "ping" stocks to identify large reserve-book orders by issuing an order very quickly, then withdrawing it. By doing this, they obtain information on a large buyer's limits. They use this to buy shares elsewhere and on-sell them to the institution.

And the "program traders," who buy large numbers of stocks at the same time to fool institutional computers into triggering large orders. By doing this, they trigger sharp market moves.

Possible Solutions to HFT-Induced Fallout

Money Morning's Hutchinson says that "this toxic trading has caused volume to explode, especially in NYSE-listed stocks. The number of quote changes has also exploded and short-term volatility has shot up. NYSE specialists now account for only around 25% of trading volume, instead of 80% as in the past."

This has major ramifications for all investors, Hutchinson says.

"The bottom line for us ordinary market participants is that insiders are using computers to game the system, extracting billions of dollars from the rest of the market," he said. "While it is illegal to trade on insider knowledge about company financials, these people are trading on insider knowledge about market order flow. That's how Goldman Sachs and the other biggest houses make so much from trading. By doing so they are rent-seeking, not providing value to the market."

According to Hutchinson, there are two solid solutions – ideally, the Securities and Exchange Commission (SEC) would employ both.

First, the SEC could introduce a rule that all orders must be exposed for a full second. That will reduce the volume of HFT, but still wouldn't truly protect non-computerized outsiders, he said.

The second, and better, solution would be to introduce a small "Tobin tax" on all share transactions. It could be tiny; maybe 0.1 cents per share. (The SEC would also need to ban "exchange rebates" to traders).

"Such a tax would make the worst HFT types unprofitable, without imposing significant costs on retail investors," Hutchinson says. "It would also provide funds to help run the vast apparatus of regulation and control that seems to be necessary to run a modern financial system. Goldman Sachs and other financial institutions of its ilk have imposed huge costs on the U.S. public with their 'too-big-to-fail' status. Now they are adding to the problem by scooping out money from the stock market through HFT. It's about time the government imposed some taxes to stop the worst of these scams and recover the public some of its money."

News and Related Story Links :