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The Electronic Menace: Algorithmic Trading

Algorithmic and high-frequency trading has been a destructive force in the stock market. How can we protect ourselves?

MILLBURN, N.J. (TheStreet) -- Algorithmic and high-frequency trading has been a destructive force in the stock market. As we have seen in just the past few trading sessions, these trading strategies and their execution platforms can create excessive dislocations both to the upside and downside in a very rapid manner and short time frame. I strongly believe that these programs add zero value to the individual investor and may extract wealth from the hundreds of millions of people whose investments and pension are invested in the equity markets.

With that in mind, I want to point you to the May 2010 issue of

Traders Magazine

. The issue was devoted to crossing network and dark pools. By extension, high-frequency and algorithmic trading was also covered in the issue.

Included in the issue was the following letter from the publisher, Kenneth Heath:

"Welcome to Traders Magazine's 2010 Special Report on Crossing Networks/Dark Pools. Crossing networks and dark pools are the subject of debate amongst regulators both in the United States and Europe. Despite any controversial aspects, these modern-day forms of non-displayed liquidity have undisputedly become essential components of the equity markets as traders seek to source liquidity and achieve best execution. "Please read on to learn about leading firms' strategies for crossing networks and dark pools and how their technologies and trading methods impact both the buyside and sellside. In addition, these firms share how they can help improve execution quality while safeguarding client orders in today's challenging, fragmented market. "We welcome your feedback on this publication. If you have any comments or questions, or if you have suggestions for additional supplemental topics, please feel free to call or email me."

I am taking up Heath's request for comments or questions, using this article as the forum for my opinion.

First, let me say that the May 2010 issue of

Traders Magazine

was tantamount to an advertising circular for the service providers who offer crossing networks, algorithmic and high-frequency trading platforms and dark pool executions.

Second, the magazine issue was very one-sided. If you state upfront that these are controversial products and services, don't you owe your readers both sides of the controversy? How does the retail brokerage industry feel about these products? What do the


and the UK's FSA think about these issues? What is the opinion of the


and other SROs?

Third, I contest that "these modern-day forms of non-displayed liquidity have undisputedly become essential components." I would not say that they are essential. The markets functioned properly before the introduction of algorithmic trading and dark pools. In fact, I think that the contrary is true. These trading products and services have exacerbated volatility and drained individual stock liquidity. In the process, the individual investor is being hurt. How have dark pools, high-frequency trading and algorithmic trading helped out the typical municipal employees' retirement plan?

Fourth, the algorithmic and high-frequency traders assert that they create liquidity to the market and individual investor. I say prove it. If you create liquidity, then you are acting much like a market maker. I do not see that function being performed.

I am disturbed by message being sent in the SuperX advertisement in the magazine. SuperX is an algorithmic trading platform offered by Deutsche Bank. That advertisement says:

"SuperX is Deutsche Bank's dark liquidity seeking algorithm. In a world of incredibly complex and rapidly evolving electronic markets, you need a partner with the smartest algorithm to access the deepest pools of liquidity. Your executions need to balance the efficiency of extracting liquidity while controlling market impact and maintaining anonymity. SuperX is dark trading made intelligent, bringing you a quantitatively engineered Smart Allocation Model and anti-gaming measures designed to prevent information leakage and systematic adverse selection for smarter liquidity. Now there's a more intelligent choice for dark liquidity, Deutsche Bank."

We have product providers who are in an arms race to provide traders with the most sophisticated money extraction machines. We are creating products to siphon off wealth from shareholders and move them to active traders. In the process, the liquidity that is purported to be created is removing liquidity from the system as more individual and traditional institutional investors are becoming distrustful of an equity marketplace no longer controlled by shareholders but by

Space Odyssey

HAL-like machines, which attempted to replace "human error" with computers.

So this raises the question: How can we inoculate ourselves against the adverse consequences of high-frequency, algorithmic and dark pool trading? Here are a few suggestions.

1. Increase minimum trading increments to 5 cents per share. The lower the incremental spread on stock trading, the higher we should expect volatility to manifest itself. Why do we need penny increments as we have now? Why do we need the

half-penny increments

that the SEC is currently considering ? The markets worked just fine with eighths and sixteenths. Let's try something in between: How about nickel increments? We broke the system by going from sixteenths, or 6.25 cents, to pennies. Try a nickel. I am perfectly happy transacting at nickel spreads. It is irrelevant to investors. Transacting at 5-cent increments might get us back to normal -- and we certainly don't have normal right now. It would also eliminate the devastating effect of high frequency algorithmic computer trading.

2. I am not a pro-tax guy. For the record, I am a proponent of lower taxes and supply-side economics, especially the

Laffer Curve

. However, there is wiggle room to consider sin taxes, such as for cigarettes and liquor. I would consider high-frequency trading as a sin upon the individual investor. So while I abhor increased taxes, I think there is room for a securities transaction tax on stocks in the U.S., such as that proposed by Nobel Laureate James Tobin for currencies. This tax was proposed to combat market volatility. Of course, a Tobin-like tax would be hated by the sell-side vendors who would lose volume, but it would protect buy-side individual investors who are being cheated by the high-frequency traders. This tax can be graduated so as not to impact the individual at-home or small-business day-trader or investor.

3. Put some visibility into high-frequency trading, which purports to fix visibility issues. Instead of funneling high-frequency, algorithmic and dark pool trades though stock exchanges and electronic communication networks, separate these traders onto separate platforms. Let the high-frequency traders knock each others' brains out, but keep them away from the poisoning the pool of stocks for investors. In other words, separate the high-frequency renters from the capital owners.

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4. Modify the way in which these traders operate in the market. Have them show firm bids and offers for a minimum period of time, and preclude them from launching market order programs. Finally, restrict them from trading futures and options except as an after-trade hedge.

5. Establish circuit breakers. Real circuit breakers. If the

S&P 500

were trading more than, say, 1.5 times (up or down, as we must be symmetrical) its historical standard deviation (that would be about 1.5%), circuit breakers would kick in. All higher-frequency trades would be blocked from execution. How do you do that? Have brokers, by regulation, segregate high-frequency and algorithmic accounts from other accounts. Commodity brokers perform a similar function for commodity accounts, which are segregated between speculators and hedgers. Thus the precedent is already there to segregate types of market participants.

6. Reinstitute the uptick rule. I know this is beating a dead horse, but nothing good has come since the SEC eliminated the uptick rule.

I welcome anyone's comments and would also be open to discuss these issues in an open forum with both supporters and opponents of these trading strategies and programs.

-- Written by Scott Rothbort in Millburn, N.J.

At the time of publication, Rothbort had no positions in stocks mentioned, although positions can change at any time.

Scott Rothbort has over 25 years of experience in the financial services industry. He is the Founder and President of

LakeView Asset Management

, a registered investment advisor specializing in customized separate account management for high net worth individuals. In addition, he is the founder of

, an educational social networking site; and, publisher of

The LakeView Restaurant & Food Chain Report

. Rothbort is also a Term Professor of Finance at Seton Hall University's Stillman School of Business, where he teaches courses in finance and economics. He is the Chief Market Strategist for The Stillman School of Business and the co-supervisor of the Center for Securities Trading and Analysis.

Mr. Rothbort is a regular contributor to's RealMoney Silver

website and has frequently appeared as a professional guest on

Bloomberg Radio


Bloomberg Television


Fox Business Network


CNBC Television

, TV

and local television. As an expert in the field of derivatives and exchange-traded funds (ETFs), he frequently speaks at industry conferences. He is an ETF advisory board member for the Information Management Network, a global organizer of institutional finance and investment conferences. In addition, he is widely quoted in interviews in the printed press and on the internet.

Mr. Rothbort founded LakeView Asset Management in 2002. Prior to that, since 1991, he worked at Merrill Lynch, where he held a wide variety of senior-level management positions, including Business Director for the Global Equity Derivative Department, Global Director for Equity Swaps Trading and Risk Management, and Director for secured funding and collateral management for the Global Capital Markets Group and Corporate Treasury. Prior to working at Merrill Lynch, within the financial services industry, he worked for County Nat West Securities and Morgan Stanley, where he had international assignments in Tokyo, Hong Kong and London. He began his career working at Price Waterhouse from 1982 to 1984.

Mr. Rothbort received an M.B.A., majoring in Finance and International Business from the Stern School of Business, New York University, in 1992, and a B.Sc. in Economics, majoring in Accounting, from the Wharton School of Business, University of Pennsylvania, in 1982. He is also a graduate of the prestigious Stuyvesant High School in New York City. Mr. Rothbort is married to Layni Horowitz Rothbort, a real estate attorney, and together they have five children.