New York Attorney General Endorses A Radical Change To The Way The World Trades Stocks

This morning New York Attorney General Eric Schneiderman declared war on high frequency traders (HFTs), and what he called the "fundamentally unfair - and potentially illegal - situations that give elite groups of traders early access to market-moving information at the expense of the rest of the market."

Of course, stopping this activity would require major changes - not just on the part of traders, but also on the part of Newswires that give HFTs an early leg up on information, and exchanges like the NASDAQ and the New York Stock Exchange.

To his credit, Schneiderman went to war armed with at least one strong suggestion - one that could drive exchanges completely up a wall.

"...stock exchanges as well as the Securities and Exchange Commission and other regulators should review the feasibility of the recommendations recently put forward by economists at the University of Chicago School of Business - an institution renowned for its commitment to free markets," said Schneiderman in a speech Tuesday morning.

The "recommendations" he refers to is actually a radical new way to match stock buyers with sellers called "frequent batch auctions." Professors Eric Budish, Peter Cramton, and John Shim laid it all out in a paper called 'The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response" in Decemeber.

Instead of trading stocks continuously throughout the trading day, with this method exchanges would sell them in auctions at intervals like once per second, or once every tenth of a second.

Traders would not be able to see the prices at each auction. Rather, the exchanges would collect the orders at the time of auction and execute them where bids match offers, thus consistently finding the right price without manipulation, according to the professors.

Basically, the hope is that this would reduce the arms race going on at high frequency trading firms, the constant need to come up with faster and faster ways to trade that complicate systems and gum up communication between exchanges and can - many say - cause flash crashes.

"I don't know if it would work," said Themis Trading's Sal Arnuk, an outspoken advocate of slowing down the speed of trading on stock exchanges. "It would certainly find resistance, as the majority of volume (not the same as liquidity) depends on arbitrage of the plumbing [communication between exchanges], and is such a substantial part of the exchanges' revenues."

In other words, exchanges may not want to implement a change that would reduce the number of orders (filled or not filled) that go through their pipelines, because they make money for the orders they get.

Arnuk continued saying: "Actually I think that many tools are in place, that if regulated properly, allow all players to coexist peacefully. HFT plumbing arbitrage would arbitrage itself into extinction without payment for order flow like maker taker and retail order buying."

That one issue. Another one at hand is what market research firm Nanex CEO Eric Hunsader calls "the show-stopper" - the fact that exchanges would have to invest in rewriting their systems to deal with a new batch auction regime.

That rewriting comes with additional problems beyond cost. Lev Lesokhin of software risk analysis firm CAST told Business Insider that putting the breaks on the "unconstrained" race for speed is long overdue, but that rewriting exchange systems to deal with auctions could make software more complex.

"If I have to build my systems to work with that kind of regiment, it makes my systems that much more complicated," said Lesokhin. "Now I have to think about -'what does that mean in terms of trading?'... If I'm trading I'm going to want to know when is that [auction] second is happening because there's value to me to wait until that very last sliver of time before the trading happens."

In other words, traders could still want to wait til that last, microscopic period of time before the auction happens to place their order. That in itself could be a whole new arms race.

"I think there's going to be ways to get around that speed limit," Lesokhin continued. "And it's going to make systems more complex. This is problem with regulation. Once you think about how it's really going to get deployed, it's not as clear as regulators would like."

Remember there's always the law of unintended consequences.