A growing number of investment professionals are saying less-than-flattering things about high-frequency trading. Proponents of this controversial practice contend it adds liquidity to the market and provides other benefits to investors. But not everybody is convinced.

One money manager, for instance, Southeastern Asset Management, an advisor to $34 billion in client accounts, including Longleaf Partners Funds, asserts that high-frequency trading allows short-term professional traders to insert themselves between long-term buyers and sellers in costly ways.

"This intermediation conservatively results in $20 billion per year in execution costs and untold billions in opportunity costs for investors," Southeastern wrote to the Securities and Exchange Commission after the agency asked for public comments on market structure. Specifically, the SEC asked market participants whether high-frequency trading allows "a substantial transfer of wealth from the individuals represented by institutional investors to proprietary trading firms."

TABB Group, a New York consulting firm, estimates high-frequency trading now accounts for 70% of daily total trades and up to 61% of daily U.S. share volume.

High-frequency trading firms can operate as stand-alone proprietary trading firms, as proprietary trading desks at multi-service broker-dealers or as hedge funds. They might trade stocks, index futures, exchange-traded funds or some combination of these and other asset classes. The common element is that they can execute massive numbers of small long or short orders in microseconds using high-speed computers and sophisticated algorithms in hopes of making a small profit on each.

The Benefits: Real Or Illusory?
Advocates claim high-frequency trading benefits all market participants, not just the traders, though the actual evidence is scant. It supposedly improves prices by narrowing bid-ask spreads, and spreads have indeed gotten thinner on many large-cap stocks. But the contribution of fast-trading to that trend is debatable, market observers say. Even if the traders are shrinking spreads, the SEC says the excessive volatility in the market often attributed to them may harm long-term investors because the short-term price movements can overwhelm the spread many times.

High-frequency trading also lowers execution costs for market participants, its advocates say, and yes, commissions, like spreads, have declined. But the CFA Institute told the SEC it believes this trading "may prove costly to the average investor who invests through large mutual funds."

"Given that HFT transactions typically execute small orders," the institute wrote, "it follows that there are higher and/or disproportionate associated costs to longer-term investment funds that must pay additional trading fees to execute many small trades to deal with large positions."

Others argue that the high volume of cancel and replace orders increases trading overhead for market participants, who must pay higher technology costs to process all the quote data.

Liquidity is another purported benefit of the practice. But high-frequency traders often display quotes only to yank them split seconds later, before others can react. Thus the liquidity these traders tout is "not real and accessible," Southeastern asserts. Such liquidity can evaporate at any time, as it did on May 6-the day of the so-called "flash crash"-when high-frequency traders halted their trading and volume and prices fluctuated wildly. Consequently, critics argue that high-frequency trading arbitrarily inflates and deflates asset prices. The traders "will trade when it is beneficial for them. They are for-profit enterprises who are not altruistically motivated," Southeastern told the SEC.

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