Last May, the Dow Jones Industrial Average suddenly plummeted around 1000 points for no apparent reason. Eventually, it was determined that a bad computer trading algorithm triggered the event. Even since, regulators have been worried about high frequency trading, a practice where traders rely on sophisticated computer programs to buy and sell securities in fractions of a second. They are now considering some rules to limit this practice. But traders argue slowing down the computers will jeopardize market efficiency. Will it?

Here's Luke Jeffs and Sara Webb of Reuters reporting:

U.S. and European regulators plan next year to introduce new rules to restrict the trading activities of these traders -- tech-savvy hedge funds that generate huge volumes of orders -- to prevent a repeat of last year's U.S. "flash crash".

But a panel of managing directors from major European investment banks told the Reuters Future Face of Finance Summit on Wednesday that punishing these traders was risky because they were a key source of liquidity that benefits all trading firms.

"If they are somehow going to outlaw or make it disadvantageous to be a market-maker, they are going to take liquidity out of the market," Jack Vensel, global head of wholesale services at Citigroup, told the Reuters Summit, in London.

First, for those who don't speak banker, liquidity in this context refers to having a vast number of buyers and sellers in the market for securities. And market makers help to unite buyers and sellers of something, like a security.

So the statement that Vensel is making above is true: if you outlaw or make it disadvantageous to be a market maker, then market liquidity will fall. In fact, it's true by definition: with fewer market-makers trading would be more difficult, as buyers and sellers would not as easily be able to find one another. The problem with this logic, however, is that it's not necessarily true that regulation on high frequency trading would outlaw or make it disadvantageous to be a market maker.

If regulators are really clueless, they could go way too far when trying to rein in electronic trading. For example, they could do something crazy like say all computers need to be removed from trading desks, and we need to go back to the days of paper, pencil, and telephones for trading. That would obviously harm market makers and overall market efficiency -- real-time quotes and transactions enhance market efficiency.

But short of banning computers, it's hard to see how reasonably restraining the speed of computer trading would harm liquidity much. Let's say that, thanks to high frequency trading, a seller of a 1000 shares of Apple stock offers it at some price. Within a nanosecond, a computer executes a purchase -- based on some criteria contained in an algorithm. So the trade occurs, and very, very quickly.

Now let's say there's a restraint that a human being must sign off on each trade with a value of more than, say, $50,000. So the same example above is mostly the same, except this time the computer senses the sale and notifies a trader, who -- probably several seconds to a minute or two later -- signs off and executives the trade, after determining that it makes sense.* Is liquidity really harmed? While it could be very slightly, in the sense that fewer big trades could get done in the same amount of time due to the new human component, the market would still be highly liquid. And you could argue that the extra safety measure is worth the probably unperceivable loss in liquidity.

Of course, this is just an example, as we have to wait to see how aggressively regulators try to crack down on high frequency trading. But it is reasonable to want to put some check on potential computer flubs. Doing so in a reasonable manner will still leave the market sufficiently efficient, and still allow traders to make lots of money. It would just slow down the pace of transactions a bit -- not knock Wall Street trading back to the 1970s.


* Quick Addendum: (which occurred to me a few minutes after posting, so to deflect some complaints about my reasoning) I understand that sometimes trades occur as the computer algorithms search for buyers/sellers, and it's only by offering to buy/sell a security at some price that the transaction can occur. That, to me, reflects a problem with the trading platform. A security should be able to be offered, and potential purchasers should be able to detect that offer (and vice-versa), without having to commit to buying/selling it instantaneously. Again, this change should not have a substantially negative effect on market efficiency.

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