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Four Ways High-Frequency Trading Harms Investors and the Economy

NEW YORK (TheStreet) -- It's clear enough that high-frequency trading affects professional traders and sophisticated market participants by obfuscating order flows and increasing short-term price instability.

We wrote an article geared toward the active trader last year and look at a different side of the story in this one.

Though the discussion about high-frequency trading is old news in the financial world, Michael Lewis' new book, Flash Boys: A Wall Street Revolt, has brought the discussion into the public eye over the last few days.

The broader and different audience now exposed to the issue demands we ask broader and different kinds of questions: How does high-frequency trading really affect individual investors and what is its macroeconomic impact?

We identify at least four ways that high-frequency trading affects investors and the economy.

1. Erodes Investor Confidence

Lewis' book portrays high-frequency traders as ruthless financial predators operating on the fringes of the law. Their activities, illegal in the spirit if not the letter of the law, are obscured within the microsecond gaps beyond regulators' reach, stealthily separating investors from their money a few pennies at a time.

The narrative is hyperbolic, but it's hard to argue with the fundamental point: the traders do seem to engage in practices that look very much like front-running, the computer systems used in high-frequency trading probe the markets using techniques that are, at the very least, rather gamey. The very heart of the systems' competitive advantage is their ability to exploit market information a fraction of a second before it becomes widely available in violation of the spirit of the law.

Even if you disagree entirely, the perception of impropriety and reduced transparency is itself a reason to worry. Because high-frequency trading now comprises a large portion of trading volume on major exchanges, anyone who that doesn't trust it also doesn't trust the exchanges.

The inherent opacity of an operation that floods the markets with millions of convoluted orders per second makes it ripe for abuse, and necessarily breeds mistrust. Because investor confidence affects macroeconomic behavior in profound ways, a widespread belief -- whether founded or not -- that abuses are occurring is a massive problem in and of itself.

2. Increases Cost of Capital

A 2012 analysis by Credit Suisse shows that "real" U.S. equity volume -- that is, not high-frequency trading -- may have hit its lowest point since 1999.

The inflated volume the high-speed traders generate doesn't reflect a genuine demand for equities and doesn't make up for the loss of real investor activity.

While the drop in real volume is not entirely related to high-frequency trading, it's hard to imagine that it doesn't play at least some role. After the experience of the IPOs of Facebook (FB) and BATS Global Markets (BATS), companies looking to raise money and their investors are right to be worried about exchanges.

So should anyone, other than traders, worry when exchange volumes drop? Yes, the effects are broad and affect the economy at large. When investors are hesitant to put money into the stock market, the lower demand for equities drives up the cost of raising capital and slows down investment activity overall.

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