Finance

From The Wall Street Journal:

Trading in dark pools and other off-exchange venues has been rising in recent years. About 14% of all stock trades in the U.S. now take place on dark pools, up from 3% in 2007, according to Tabb Group, which tracks electronic trading. Total trading away from exchanges hit a record of 37% of all trading volume in January, according to NYSE Euronext NYX -0.65%.

A rise in off-exchange trading could hurt investors, some said. A 2010 study by Rutgers Business School professor Daniel Weaver found that a NYSE-listed stock with 40% of its volume trading in the dark costs investors about $4 million per stock a year.

The reason: With more investors trading in the dark, fewer buy and sell orders are being placed on exchanges. That can translate into worse prices for stocks, because prices for stocks are set on exchanges.

Exchanges have been scrambling to turn the tide. One tactic in recent years has been to cater to high-frequency firms in order to capture the rivers of buy and sell orders they provide. With more orders on the exchanges' books, investors might get better prices and find it easier to trade, they hoped.

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Finance and Economics Professor Daniel Weaver participated in a panel discussion hosted by The Wall Street Journal on the subject of financial markets. The following are exchanges between WSJ and Prof. Weaver.

WSJ: What does high-frequency trading mean? What are these firms doing, and to what extent have they replicated the role of floor traders?

Prof. Weaver: The average high-frequency trader's profit is 10 cents on 100 shares traded. When you have a machine, it becomes scalable and very profitable to make very small profits per trade.

WSJ: How does it affect individual investors?

Prof. Weaver: Whether or not there is more volatility in the marketplace is the issue. It's not clear whether more volatility is being caused by high-frequency traders. Certainly there are tighter spreads, more liquidity. But there's more price impact, and there may be more volatility in the market as well.

WSJ: Should retail investors be concerned?

Prof. Weaver: They should stay away from short-term trading strategies. They are going to go up against computers and lose. But put it in perspective. IBM shares traded at about $80 on Feb. 28, 2006. If you ended up paying an extra 25 cents a share due to volatility, then you paid an extra 25 cents per share. Over the next five years IBM doubled, which impacts returns much more than the 25 cents. Investors should worry about the long-term price appreciation of stocks, not small volatilities.

WSJ: What about the impact high-frequency trading has on exchanges' trading networks?

Prof. Weaver: We have to worry about stresses on the system. The Tokyo Stock Exchange had to shut down twice in the past six years because their systems could not handle the volume of traffic. As high-frequency traders scale up, we're going to need more improvements to the structure of exchange backbones. If we don't have that, we could have a crash precipitated just because the exchanges couldn't handle the message traffic.

WSJ: Electronic traders are often portrayed as secretive and predatory. What can they do to improve their public image?

Prof. Weaver: If they have nothing to hide, then show us the data. It'll have to be coded so that we can't identify any individual firm and replicate their trading activities. But there are ways, which Nasdaq has done, to release the data without the high-frequency-trading firms fearing that their trading strategies can be discerned by looking at the data.

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Does the liquidity of a particular stock – that is, the ease with which investors can buy and sell the shares – impact investors’ decisions to acquire the stock, and then their ability or desire to get involved with management to improve governance and performance? Alex Edmans of the Wharton School, Vivian Fang of Rutgers University, and Emanuel Zur of Baruch College examined this question and published their findings in a recent paper, “The Effect of Liquidity on Governance.”

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