In the summer of 2009, the press had a collective freak-out over so-called "high-frequency trading," where math, physics, and AI whizzes from the nation's top universities program the world's most powerful computers to trade against one another on electronic stock exchanges for microsecond advantages and billions of dollars. That's actually how the markets work now. But by the end of the year, the frenzy had died down, as such frenzies do. The practice is back with a vengeance in 2010, and the SEC is close to wrapping up the first phase of its investigation into the issue. It will surprise no one that one of the reforms being seriously considered is not a reform at all.

The SEC kicked off its investigation this past January with the release of a very good, quite readable 74-page document [PDF] on market structure in the age of electronic trading. The agency then asked for comments from the public—everyone from large institutional investors and hedge funds to individual traders—on any and all aspects of the way our markets currently operate.

The release contains some good charts and data showing the degree to which various forms of electronic trading have changed the complexion of the markets by drastically decreasing the amount of time it takes to execute a trade, decreasing the number of trades per day that take place on the NYSE (many take place in other electronic venues), and massively increasing the number of shares that change hands in a day. In other words, the market for NYSE-listed stocks are now very fast and very high volume, but most of that activity isn't taking place on the NYSE itself. (The report focuses on the NYSE.)

Based on the metrics used in the report, there's no question that the market for US stocks is very different in key respects from what it was in 2005, so what the SEC is essentially asking the public is, are the markets better or worse off for all the changes? The agency is especially focused on how the changes impact long-term investors, and on the question of whether long-term, buy-and-hold investors can (and will) fairly and profitably participate in a market dominated by the kind of "trading battlebots" described above. The document acknowledges that these are open questions, hence the request for public comment.

Fairness, technology, and the big picture

Much of the release's discussion around high-frequency trading, electronic crossing networks, dark pools, and other beasts in the electronic trading menagerie focuses on fairness, and on possible ways of defining fairness in light of technological advances. One of the core issues in this regard is the practice of colocation, where trading firms pay big money for the privilege of locating their servers on the same premises as the exchange's servers (in some cases, in the same rack). This physical proximity gives a latency advantage over their competitors, and high-frequency traders can use that very thin edge to reap huge profits.

In the concept release and in recent public remarks, the SEC has both contemplated a ban on colocation and (in the same breath) acknowledged that such a ban would amount to a technologically illiterate nonreform. If you banned colocation, the latency competition would just move into an adjacent building; this is because the competition isn't for the lowest absolute latency, but for the lowest latency relative to competitors. So increasing everyone's absolute latency by banning colocation solves exactly nothing, and the SEC knows and admits this.

This is the point where the agency throws up its hands and turns the question on the public, but mostly in a manner that weakly attempts to disguise rhetorical questions as real ones. For instance, pages 41 and 42 of the concept release ask, "What standards should the Commission apply in assessing the fairness of the equity markets? For example, is it unfair for market participants to obtain a competitive advantage by investing in technology and human resources that enable them to trade more effectively and profitably than others?" Obviously, any reasonable person will answer the second question with a "no." And this is why, instead of issuing a public request for comments, the SEC would have done better to issue a public request for better questions first.

Most of the questions surrounding HFT are big-picture questions about the safety, sanity, and social costs of having a financial sector that sucks up so much of the brainpower of our collective best and brightest, and puts that brainpower to work producing secret technologies for making money by moving money around. In a bygone era, all of these math, science, and engineering brains would have been employed by US industries to make things that Americans can either sell to foreigners or kill them with. Today, Americans make who-knows-what advances in AI, pattern recognition, language processing, data analysis, information retrieval, etc. that never find their way into either a commercial product or a peer-reviewed journal.

And then there's the question of potential downsides to turning our markets into massive, networked information systems that operate in many cases not only without human intervention, but faster than humans can possibly react and intervene.

Instead of asking if it's "unfair for market participants to obtain a competitive advantage by investing in technology and human resources that enable them to trade more effectively and profitably than others," perhaps the SEC (or Congress) should ask if it's good for the country. Or, to put it in terms that Wall Street understands, is it "fair" to focus so exclusively on the efficiency of markets in allocating capital, that we allow a massive misallocation of precious human capital to occur?

Perhaps it's the case that these more important, bigger-picture questions are beyond the SEC's purview. If so, they should be taken up by Congress.

As for things that the SEC can either do or recommend to address the challenges posed by HFT, there's actually a straightforward way to tell if someone is serious about reforming a particular financial sector practice: if they propose just changing the rules (as with the colocation idea), they're not serious; if they propose changing incentives, they are.

For instance, it's popular among Wall Street types to claim that if you want less of something, you tax it. This idea works great for HFT. The many proposals to heavily tax the proceeds from microsecond trades are made by people who are serious about seeing the bulk of market activity shift away from "trading battlebots" and back towards long-term investing, because that would make the behavior unprofitable.

In contrast, consider the ultimate rule change: a total ban on computer-automated trading of any sort. Such a rule would just create incentives for firms to design algorithms that can disguise their trading activity to look like it's coming from an office full of humans.

All of this is not to say that the rule changes contemplated in the document, especially around dark pools, liquidity rebates, and mass order cancellations, wouldn't level the playing field a bit for smaller trading shops and individuals. But it may be up to Congress to address the larger questions of balance, fairness, and incentives in a way that amounts to real reform.