Chuck Schwab and Walter Bettinger issue call to squash flash traders but RIAs question hysteria over the issue

*Brooke’s Note: This article shows that even as Schwab becomes a bona fide provider of long-term financial advice, its DNA remains squarely in the
transactional realm. For now it is unthinkable that Schwab would so publicly and ardently write a letter like this one regarding the importance of fiduciary care. But when it sees shoddy treatment of day traders, it is all over it. There does not to appear to be any flaw in Schwab’s arguments and HFT is a problem demanding a remedy. But, as can be seen from RIA comments here, there is a question about where Schwab chooses to place its severest emphasis.*

The Charles Schwab Corp. has declared war on high-frequency traders and it is willing to stand behind whatever measures it takes — including government intervention — to purge the scourge from the Earth.

The San Francisco-based company posted a statement on its website today, co-signed by the founder and chairman himself and chief executive Walter Bettinger — that reads a bit like a cross between an op-ed piece and a legal brief.

The statement (see whole document at the end of this article) assails high frequency traders as a threat to the very underpinning of our economy and markets.

“The fuel of our free-enterprise system, capital formation, is at risk. We can’t allow that to happen,” they write.

The Schwab letter seems to have had a bad effect on the share prices of the discount brokers, particularly E*Trade, down $1.53 or 6.5% and TD Ameritrade, down $1.80 or 5.3%. Schwab’s shares fared better with its shares losing a more modest 1.9% of their value. The shares were helped none by a Goldman Sachs report slamming them.

Meanwhile, many RIAs remain unfazed — as this newsletter sent out by Sausalito, Calif.-based Bob Goldman Financial Planning Inc. shows:

“If you are a short-term trader of specific stocks, you probably do face structural disadvantages, but if you are long-term, passive, index investor, you may actually benefit from the cost savings produced by HFT,” Goldman writes. “Even if Wall Street is not perfect, where else are you going to go to get the Wall Street returns most of us require to meet our goals?”

True — but beside the point?

Though the dollar impact of the traders on any given portfolio has been shown to nick returns marginally, there is a broader concern expressed by the Schwab leader — the erosion of confidence.

The markets are already very much on probation in the mind of the mass-market investor that uses Schwab and other discount brokers to trade in the wake of the 2008-2009 meltdown. Only recently there have been signs that investors are finding trust again in the system and their ability to invest competitively with professionals in the market. See: What RIAs need to know about systemic risks in the wake of the flash crash.

Norm Boone, founder and president of Lafayette, Calif.-based Mosaic Financial Partners republished with permission commentary written by Bob Veres on the subject.

“The charge [against traders] is essentially true. And it is also completely irrelevant to you and anyone else who practices patient investing …. Why is this irrelevant to you? Many of those lost dollars are coming out of the pockets of day traders, ordinary people who are foolish enough to think that they can outwit the markets by moving into and out of individual stocks several times a day, or professional traders at hedge funds who may not have access to the fastest server or a direct feed into the Nasdaq servers. There are tens of thousands of these investors, and many of them, watching the 60 Minutes report, discovered for the first time that they are getting routinely fleeced by Wall Street’s money machine.” See: How ETFs have been oversold when it comes to flexibility, lower costs and tax efficiency.

In an email Boone added this thought about Schwab’s letter and Veres’ thoughts on the matter: “I think Schwab and everyone else ought to attack the problem with full resources because it represents unfairness, however slight, and that is just not right; at the same time, as my commentary (Bob’s) suggested, I DO believe that this fairness is largely irrelevant to most of our clients and friends.”

Norm Boone: It is also
completely irrelevant to you and anyone
else who practices patient investing.

Storm warnings

Schwab has sounded alarms in the past about traders jumping the line to buy shares, pump up the price and resell it at a profit — all in a millisecond. Schwab ran an opinion piece in the Wall Street Journal last summer on the topic.

The big broker has also taken stances on topics it feels present a danger to its profits and investors’ fortunes, says Tim Welsh, a former marketing director at the company and now principal at Nexus Strategy. He recalls the stand (anti) it took on chronically low interest rates in past years. See: Why Chuck Schwab is fine with boosted taxes — and even Dodd Frank — and believes RIAs should be, too.

300,000 trade inquiries

The Schwab declaration comes in a week in which Michael Lewis promoting his new book, “Flash Boys,” which effectively documents the extent of the problem — and how it continues to accelerate. He kicked off his book tour on a 60 Minutes episode that aired Sunday.

The Schwab letter picks up on Lewis’s hard facts.

“Data last year from the Financial Information Forum showed this is no minor blip. High-frequency trading pumped out over 300,000 trade inquiries each second last year, up from just 50,000 only seven years early. Yet actual trade volume on the exchanges has remained relatively flat over that period.”

Veres believes that the 60 Minutes piece failed to put the flash trading into its full perspective.

“Your mutual fund that buys when a stock seems cheap might, if it’s careless or unsophisticated, give up fractions of a cent on its purchases, but that likely isn’t going to have a measurable impact on your own long-term investment returns,” he writes.

He adds: “Somehow, this important fact was lost in the 60 Minutes interview. The interview also didn’t mention that things can go horribly wrong in the arcane and predatory world of rapid-fire trading. The Hall of Fame of trading losses includes $9 billion lost in credit default swaps by a single Morgan Stanley trader from 2004 through 2006, or the $7.2 billion lost by Societe Generale trader Jerome Kerviel over a few days in 2008, or the $2 billion “London whale” losses in 2012. They—and many others—used their milliseconds speed advantage to generate staggering losses, proving that even the smartest operators aren’t always raking in the profits.

Tilted field

Still, the Schwab letter points out that the damage flash trading causes may exceed the pennies collected by beating slower footed individual investors to the punch. .

“Last year, more than 95% of high-frequency trader orders were cancelled, suggesting something else besides trading is at the heart of the strategy,” it says. “Some high-frequency traders have claimed to be profitable on over 99% of their trading days. Our understanding of statistics tells us this isn’t possible without some built in advantage. Instead of leveling the playing field, the exchanges have tilted it against investors.”

So where’s the real harm?

“Professionals are mining the detailed data feeds made available to them by the exchanges to sniff out and front-run large institutions (mutual funds and pension funds), which more often than not are investing and trading on behalf of individual investors,” the Schwab letter says.

High-frequency trading is a growing cancer that needs to be addressed.

Schwab serves millions of investors and has been observing the development of high-frequency trading practices over the last few years with great concern. As we noted in an opinion piece in the Wall Street Journal last summer, high-frequency trading has run amok and is corrupting our capital market system by creating an unleveled playing field for individual investors and driving the wrong incentives for our commodity and equities exchanges. The primary principle behind our markets has always been that no one should carry an unfair advantage. That simple but fundamental principle is being broken.

High-frequency traders are gaming the system, reaping billions in the process and undermining investor confidence in the fairness of the markets. Its a growing cancer and needs to be addressed. For sure, we still believe investing in equities is a primary path to long-term wealth creation, and we believe in the long-term structural integrity of the markets to deliver that over time for individual investors, which is all the more reason to be vigilant in removing anything that creates unfair advantage or undermines investor confidence.

On March 18, New York Attorney General Eric Schneiderman announced his intention to continue to shine a light on unseemly practices in the markets, referring to the practices of high-frequency trading and the support they receive from other parties including the commodities and equities exchanges. He has been a consistent watchdog on this matter.

As Michael Lewis shows in his new book Flash Boys, the high-frequency trading cancer is deep. It has become systematic and institutionalized, with the exchanges supporting it through practices such as preferential data feeds and developing multiple order types designed to benefit high-frequency traders. These traders have become the exchanges favored clients; today they generate the majority of transactions, which create market data revenue and other fees. Data last year from the Financial Information Forum showed this is no minor blip. High-frequency trading pumped out over 300,000 trade inquiries each second last year, up from just 50,000 only seven years early. Yet actual trade volume on the exchanges has remained relatively flat over that period. Its an explosion of head-fake ephemeral orders not to lock in real trades, but to skim pennies off the public markets by the billions. Trade orders from individual investors are now pawns in a bigger chess game.

The United States capital markets have been the envy of the world in creating a vibrant, stable and fair system supported by broad public participation for decades. Technology has been a central part of that positive story, especially in the last 30 years, with considerable benefit to the individual investor. But today, manipulative high-frequency trading takes advantage of these technological advances with a growing number of complex institutional order types, enabling practitioners to gain millisecond time advantages and cut ahead in line in front of traditional orders and with access to market data not available to other market participants.

High-frequency trading isnt providing more efficient, liquid markets; it is a technological arms race designed to pick the pockets of legitimate market participants. That flies in the face of our markets founding principles. Historically, regulation has sought to protect investors by giving their orders priority over professional orders. In racing to accommodate and attract high-frequency trading business to their markets, the exchanges have turned this principle on its head. Through special order types, enhanced data feeds and co-location, professionals are given special access and entitlements to jump ahead of investor orders. Last year, more than 95 percent of high-frequency trader orders were cancelled, suggesting something else besides trading is at the heart of the strategy. Some high-frequency traders have claimed to be profitable on over 99 percent of their trading days. Our understanding of statistics tells us this isnt possible without some built in advantage. Instead of leveling the playing field, the exchanges have tilted it against investors.

Here are examples of the practices that should concern us all:

Advantaged treatment: Growing numbers of complex order types afford preferential treatment to professional traders orders, most notably to jump ahead of retail limit orders.

Unequal access to information: Exchanges allow high-frequency traders to purchase faster data feeds with detailed information about market trading activity and the specific trading of various types of market participants. This further tilts the playing field against the individual investor, who is already at an informational disadvantage by virtue of the slower Consolidated Data Stream that brokers are required by rule to purchase or, even worse, the 15- to 20-minute-delayed quote feed they have public access to.

Inappropriate use of information: Professionals are mining the detailed data feeds made available to them by the exchanges to sniff out and front-run large institutions (mutual funds and pension funds), which more often than not are investing and trading on behalf of individual investors.

Added systems burdens, costs and distortions of rapid-fire quote activity: Ephemeral quotes, also called quote stuffing, that are cancelled and reposted in milliseconds distort the tape and present risk to the resiliency and integrity of critical market data and trading infrastructure. The tremendous added costs associated with the expanded capacity and bandwidth necessary to support this added data traffic is ultimately borne in part by individual investors.

There are solutions. Today there is no restriction to pumping out millions of orders in a matter of seconds, only to reverse the majority of them. Its the life-blood of high-frequency trading. A simple solution would be to establish cancellation fees to discourage the practice of quote stuffing. The SEC and CFTC floated the idea last year. It has great merit. Make the fees high enough and they will eliminate high-frequency trading entirely. But if the practice is simply a scam, as we believe it is, an even better solution is to simply make it illegal. And exchanges should be neutral in the market. They should stop the practice of selling preferential access or data feeds and eliminate order types that allow high-frequency traders to jump ahead of legitimate order flow. These are all simply tools for scamming individual investors.

The integrity of the markets is at the heart of our economy. High-frequency trading undermines that integrity and causes the market to lose credibility and investors to lose trust. This hurts our economy and country. It is time to treat the cancer aggressively.

Charles Schwab, Founder and Chairman
Walt Bettinger, President and CEO