A SHORT HISTORY OF FAST TIMES ON WALL STREET / THE NEW YORK TIMES OP EDITORIAL ( RECOMMENDED READING )

September 18, 2009

Op-Ed Contributor

A Short History of Fast Times on Wall Street

By DAVID SILVER
Washington

MANY fear that new technology is giving some investors unfair access to stock market information. Supercomputers allow certain traders to profit by executing trades in milliseconds, a practice known as high-frequency trading. These traders also use a technique called flash orders that gives them a sneak peek at other investors’ orders to buy and sell stock. High-frequency traders are said to have made $21 billion in profit last year.

This may seem like a 21st-century problem. But in fact, similar criticisms have been made for over 100 years, since the days when trades on the New York Stock Exchange were executed by humans using notepads and pencils.

Even back then, critics claimed that the exchange members who were physically present on the floor could get trading information and execute their own orders faster than anyone else. The creation of the Securities and Exchange Commission in 1934 included the power to regulate the buying and selling of securities by exchange members trading for themselves, rather than for customers.

A Roosevelt administration official testifying in support of the 1934 legislation, Thomas Corcoran, described such floor traders as “chiselers.” This referred to their ability to quickly buy from sellers at prices lower than they would otherwise get, and promptly resell to buyers at prices higher than they would otherwise pay.

These complaints were well founded. By being on the exchange floor, traders could see with their own eyes the prices of completed trades minutes before they appeared on the exchange tape. Executing their own orders gave them a head start over ordinary investors, whose orders could take minutes to reach the floor. As a former Wall Street Journal editor wrote in 1903, “They know the prices even before they are recorded on the tape, and they are able to join in every upward movement the moment it begins, and to abandon it the moment it shows signs of wavering.”

In 1909, a committee created by Gov. Charles Evans Hughes of New York to study stock market abuses similarly commented that floor traders “acquire early information concerning the changes which affect the values of securities,” giving them “special advantages” over other traders.

In 1963 a congressionally mandated report on the securities markets found that floor trading conferred unfair advantages and should be abolished. Consequently the S.E.C. required that the major exchanges ban most floor trading, an exception being trading to contribute to “orderly” markets — that is, markets not subject to violent price fluctuations.

This action, however, proved to be a temporary fix. Today, there’s little need to be on the trading floor: computer technology creates new opportunities to acquire and preferentially trade on inside market information. While these advantages are measured in milliseconds rather than minutes, both high-frequency trading and flash orders enable certain investors to chisel a profit between bid and offer — the same abuse of inside market information and access that the S.E.C. tried to eliminate four decades ago. Now, traders have simply found different ways to tilt the playing field, which means that the S.E.C. will have to update its regulations to preserve equal access to securities markets. The sooner it does that, the better.

But it would be a mistake to assume that we are facing a new problem. Today a major defense of high-frequency trading and flash orders is that they add liquidity to the markets. This was true of floor trading as well, but as the 1963 report pointed out, added liquidity “cannot justify trading that in other respects is deleterious.”

There are other similarities as well. Today, high-frequency traders are said to rent space as close as possible to stock exchange computers in order to pick up an extra millisecond of advantage. In early 19th-century New York, those seeking inside market information rented space next to the exchange and bored holes in the wall so they could eavesdrop.

On Wall Street, someone will always look for a way to be first, whether it’s fair or not.

David Silver, a former senior staff lawyer at the Securities and Exchange Commission, was the president of the Investment Company Institute, a trade association for mutual funds, from 1977 to 1991.

Copyright 2009 The New York Times Company