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In high-frequency trading, ‘a millisecond is worth a fortune’

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High-frequency trading is being scrutinized by regulators in Canada, the United States and Europe who fear the use of sophisticated technology to buy and sell stocks at super-fast speeds is benefiting speculators and hurting the everyday investor.

Two weeks ago, a European parliament committee voted to bring in sweeping reforms of securities markets in response to high-frequency trading. The U.S. Securities and Exchange Commission has set up an office of analytics to study just how market behaviour is being influenced by the increasingly fast and efficient technology.

And here, the Investment Industry Regulatory Organization of Canada is undertaking an intensive study to see how markets are being influenced. What the study has looked at so far is the prevalence of this activity – 42 per cent of all trades in the Canadian market and 32 per cent of the value traded.

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"High-frequency traders can see things a millisecond ahead of the rest of us, but a millisecond is worth a fortune," says Eric Kirzner, a professor at the University of Toronto's Rotman School of Management who also holds the John H. Watson chair in value investing. "They can see what slow-moving traders are doing and move ahead of them.

"This is sort of a 'tragedy of the commons' situation where the high-frequency traders have found a way to exploit the market in the short run, but run the risk in the long run of spoiling the markets for everyone," says David Baskin, president of Baskin Financial Services Inc. in Toronto, an unabashed critic of the practice.

Proponents of high-frequency trading say they are doing nothing wrong, and their speed is actually helping the markets by improving liquidity. Increased liquidity can ease the buying and selling of securities, reduce bid-asked spreads, lower trading costs and improve price discovery.

Opponents cite increased volatility in the markets, which makes pricing less efficient, as well as the erosion of investor confidence – especially because of a few unsettling, extreme events in which high-frequency trading played a role. One of those occurred in August, when Knight Capital Group Inc. lost $440-million (U.S.) after an upgrade to its computerized trading system went awry, causing share prices on the New York Stock Exchange to fluctuate wildly after Knight put out a huge number of buy and sell orders.

"The problem is, nobody knows for sure who is right," Prof. Kirzner says. "There's all kinds of anecdotal stuff out there, but real research hasn't been done yet."

To really understand high-frequency trading, investors have to grasp three concepts about markets, Prof. Kirzner says. The first is that Canada, like the United States, has a fragmented market structure – with a primary exchange in Toronto, an options exchange, but also a number of alternative trading systems, including dark pools (which usually involve bulk trades by financial institutions that are outside of public exchanges).

"Price discrepancies, even fractions of a penny, can occur between markets at any given time," he says. And those discrepancies are exploited by high-frequency traders.

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The second concept is how computer systems work – high-frequency trading is done by fast, high-efficiency computers that are often set up in close proximity to an exchange or trading pool.

The third is that there are two basic types of traders, high-frequency and slow-moving. For the latter, think mutual-fund companies, pension funds and everyday retail investors.

"There are opportunities for market manipulation to occur – if you're seeing things before anyone else, if you can move ahead of everybody else. And in particular if you are 'spoofing' your orders, if you're flooding the market with orders and withdrawing them, if you're artificially affecting prices so you can trade against them later on," Prof. Kirzner says.

The pressure that high-frequency trading puts on regulators, on market surveillance and market enforcement, is enormous, he adds.

Mr. Baskin believes that regulators will eventually step in and bring in new rules, mostly because high-frequency trading detracts from the credibility of the public markets.

"For the average investor, this is invisible. They can't tell when they go on their trading online site to buy 100 shares of this or 100 shares of that.

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"What happens is they read about this … and it occurs to them that they're not playing on a level playing field with these institutions. And that they may be participating in a rigged game."

Murray Leith, director of investment research at Vancouver-based Odlum Brown Ltd., agrees that markets should be policed properly to eliminate flash crashes and maintain investor confidence.

But, he says, he's interested in finding investments that are undervalued but will rise to their true value in the long term, as opposed to the minute machinations that high-frequency traders are interested in.

"If I see something that I like at the right price, I buy it. If it's not at the right price, I don't. It's as simple as that."

He adds that there can even be a bright side of volatility – "it potentially creates opportunity that may not otherwise exist."

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