The importance of regulation

Capitalism without regulation is prone to excesses, driven by individuals pursuing their own self-interest. Price-gouging and provision of inferior quality goods and services are held in check by competition, but there are other aberrations against public morals, or not in the public interest, that require regulation. Historical examples would be the use of slaves, the opium trade, usury, prostitution, child labor, conquest and exploitation of primitive cultures, and sale of weapons or related technology to a nation’s enemies.

Regulation is also required to curb monopolistic practices, where competition is ineffective. There is much talk of the importance of free markets, but unregulated markets are not free. They are prone to cheating, corruption and abuse of market power. What is needed are efficient markets, where there are:

  • low barriers to entry for new participants
  • low transaction costs
  • equal access to information, at the same time

Stock markets are often quoted as an example of an efficient market. Regulation has contributed to this over the years by policing illegal activities such as insider trading, front-running, wash sales, pump and dump, price manipulation, squeezes, and disseminating false or misleading information. But lately the prevalence of high-speed trading has eroded investor confidence, as most market participants no longer have access to price information at the same time. If this continues, the onus is on regulators to allow competitors to set up efficient markets for investors.

For Superfast Stock Traders, a Way to Jump Ahead in Line – WSJ.com

By SCOTT PATTERSON and JENNY STRASBURG

Haim Bodek was a Wall Street insider at Goldman Sachs and UBS before launching his own [high-frequency] trading firm.

Mr. Bodek approached the Securities and Exchange Commission last year alleging that stock exchanges, in a race for more revenue, had worked with rapid-fire trading firms to give them an unfair edge over everyday investors.

He became convinced exchanges were providing such an edge after he says he was offered one himself when he ran a high-speed trading firm—a way to place orders that can be filled ahead of others placed earlier. The key: a kind of order called “Hide Not Slide”………

via For Superfast Stock Traders, a Way to Jump Ahead in Line – WSJ.com.

How to keep markets safe in the era of high-speed trading | Chicago Fed

By Carol Clark

With the chance of an order passing though controls at so many levels, how can things go wrong? One possibility Chicago Fed researchers found is that most of the trading firms interviewed that build their own trading systems apply fewer pre-trade checks to some trading strategies than others. Trading firms explained that they do this in order to reduce latency.

Another area of concern is that some firms do not have stringent processes for the development, testing, and deployment of code used in their trading algorithms. For example, a few trading firms interviewed said they deploy new trading strategies quickly by tweaking old code and placing it into production in a matter of minutes. In fact, one firm interviewed had two incidents of out-of-control algorithms. To address the first occurrence, the firm added additional pre-trade risk checks. The second out-of-control algorithm was caused by a software bug that was introduced as a result of someone fixing the error code that caused the first situation.

The study also found that erroneous orders may not be stopped by some clearing BDs/FCMs because they are relying solely on risk controls set by the exchange. As noted earlier, however, risk controls at the exchange may be structured in such a way that they do not stop all erroneous orders.

via Chicago Fed Letter (PDF)

BD = broker-dealer

FCM = futures commission merchant

Study: High-Speed Trading Hurts Long-Term Investors – WSJ.com

SCOTT PATTERSON: Investors trying to trade cost-effectively often find themselves standing in line behind the fleet-footed traders and are forced to wait to execute their trades, which in turn can cause poorer results, the report [by Pragma Securities LLC — a research and trading firm] says. The upshot: Investors are often paying more for many blue-chip stocks than they would have otherwise.

The results contradict a number of industry and academic studies that claim high-speed trading has cut costs for investors.

via Study: High-Speed Trading Hurts Long-Term Investors – WSJ.com.