Credit Suisse is launching a trading venue that will keep HFT traders at bay (Jim McTague)

High-frequency trading firms love to buy from

and sell to "dumb" individual

and institutional investors.

By Jim McTague 
Barron's
1/22/2011

Yummy, yummy! The good news for high-frequency traders is that juicy retail sheep again are grazing in the domestic equities market, just waiting for the slaughter.

The latest data show the first major weekly inflow of retail investment money into domestic equity funds since the flash crash this past May. These investors plunked down $3.8 billion into the equity funds the week ending Jan. 12, according to the Investment Company Institute. During 2010, they withdrew an estimated $82 billion, in part because they were spooked by the flash crash, when the Dow plunged more than 700 points in 10 minutes and then climbed 300 points in the next 10. That thrill ride was aided and abetted by high-frequency traders using over-clocked computers to front-run panicked retail investors.

These traders program their computers to buy and sell millions of shares of stock every minute, based on short-term trends, not the underlying fundamentals of the companies. Risk-averse to an extreme, their goal is to make a penny or so on each trade. It's easier for a machine to predict correctly if it is looking ahead only by a second or two. If the traders execute the same trades simultaneously, they can trigger dramatic market swings.

High-frequency trading firms love to buy from and sell to "dumb" individual and institutional investors. Individuals tend to place market orders rather than using limit orders at or below the bid price. Thus, they pay the maximum. As for mutual funds and other institutional investors, they are easily front-run by the new trading operations, which have faster access to market data as well as faster trading computers. If the funds are buying a particular stock, the traders' computers can detect this activity, buy up shares ahead of the fund and sell it back to the fund for a profit of a cent or two. This runs up the costs for mutual fund investors.

THE SECURITIES AND EXCHANGE COMMISSION has been mulling some curbs on high-frequency trading to shield long-term investors. But the plodding agency likely will take a year or two to enact any changes, and by then the math whizzes at the trading firms will have figured out another way to make chops out of the retail and institutional lambs.

Fortunately, there is a promising free-market response. Credit Suisse in March will launch what it calls the Light Pool, a trading venue for mutual funds and institutional investors that purposely puts high-frequency traders at a disadvantage. This is revolutionary. High-frequency traders are courted by the 13 major stock exchanges because they deliver trading volume and pay big bucks for concierge services, like the direct data feeds from the exchanges that give them a crucial informational head start of several milliseconds. Dan Mathisson, managing director of Credit Suisse's advanced-execution services, says the trading firms will have to route trades to the Light Pool through an outside stock exchange. "That extra hop could add 100-to-200 milliseconds to a trade, enough time to be very discouraging to high-frequency traders," he says.

High-frequency firms claim they bring benefits to the market, such as liquidity, and thatcritics exaggerate their alleged abuses. Yet Light Pool is getting strong indications of interest from institutional investors. Sal Arnuk of Themis Trading in Chatham, N.J., compares the new venue to the "tipping of a hat" to criticisms of the new traders that he and colleague Joe Saluzzi raised in 2008.

Too bad there's no Light Pool for individuals yet. Out among the wolves, they're apt to get eaten up again and again. Add'l good articles from Jim McTague