It sounds like science fiction — something from I, Robot or The Terminator, where the machines take over. But totally automated “high-frequency trading” is part of the stock market right now — a big part.

According to some estimates, high-frequency trading by investment banks, hedge funds and other players accounts for 60% to 70% of all trades in U.S. stocks, explaining the enormous increase in trading volume over the past few years. Profits were estimated at between $8 billion and $21 billion in 2008.

Some market observers, members of Congress and regulators are worried. Are those profits coming out of ordinary investors’ pockets? Is Wall Street’s latest qet-rich-quick scheme going to harm innocent bystanders? “I don’t think it would hurt people to become educated as to the intent of these strategies,” says Wharton finance professor Robert F. Stambaugh. “What is their effect on the markets? There is a little sense of 2001: A Space Odyssey [in that it] does kind of create an air of mistrust.”

Its defenders say high-frequency trading improves market liquidity, helping to insure there is always a buyer or seller available when one wants to trade. And so far, high-frequency trading doesn’t look threatening, according to several Wharton faculty members. Indeed, it may well provide benefits to mutual fund investors and other market participants by reducing trading costs. But at the same time, several note that not enough is known about how trading at light-speed works, whether it can be used to manipulate markets or whether benign-looking moves by different players could interact to produce a new financial crisis.

“High-frequency trading involves investors with good computers taking advantage of small discrepancies in prices,” says Wharton finance professor Marshall E. Blume. “Generally, economists think that drives prices back to where they should be…. If they bring liquidity to the market and make prices more accurate, then that’s good. Now a concern, which is hard to document, is that somehow these traders manipulate the market, which would be bad.”

Turning decision-making over to machines has not always benefited humans, notes Wharton finance professor Itay Goldstein. “People believe the crash of ’87 was caused by this kind of computer-based trading.” In that case, a vicious cycle swirled out of control as computerized trading programs dumped stocks in response to falling prices, causing other programs to do the same.

Traveling at Light Speed

High-frequency trading refers to computerized trades seeking to profit from conditions too ephemeral for a human to exploit, like a miniscule increase in the spread between bid and ask prices for a given security, or a slight price difference for a stock traded on various exchanges. Trading is so fast that some firms locate their server farms near the exchange’s computers, to shorten the distance orders must travel through cables at light speed.

Aside from being made possible by the proliferation of high-speed computers, high-frequency trading has evolved out of several regulatory changes. In 1998, the Securities and Exchange Commission’s Regulation Alternative Trading Systems opened the door to electronic trading platforms to compete with the major exchanges. A couple of years later, the exchanges started quoting prices to the nearest penny rather than 16th of a dollar, causing spreads between bid and ask prices to narrow and forcing traders who made money on those price differences to look for alternatives. Finally, the SEC’s Regulation National Market System of 2005 required that trade orders be posted nationally instead of only at individual exchanges. This allowed quick-moving traders to profit when a stock traded at a slightly different price at one exchange versus another.

With the effects of the subprime crisis still being felt, regulators and lawmakers are especially alert to any dangers that might lurk in unfamiliar Wall Street products and strategies. Alarm bells started going off with news accounts this summer about “flash orders,” a subset of high-frequency trading that exploits regulatory loopholes to give favored traders notice of orders a fraction of a second before they are transmitted to everyone else. Flash trading has been widely condemned as giving a favored few an unfair advantage.

“Some people are getting advantages that others aren’t, and that may lead to abuse,” says Wharton finance professor Franklin Allen. “It is a form of front running.” Front running, which is generally illegal, means improperly profiting by using advance information to jump ahead of someone else’s trade. In the textbook example, a broker receives a customer’s order to buy a stock for up to $10 a share. The broker buys the shares at the market price of $9.75 and sells them to his customer at $10, cheating the customer out of 25 cents a share. Flash orders can do the same thing, much faster and more often.

Flash trading now appears to be on the way out. In mid-September, the SEC proposed a ban, and the Nasdaq market quickly moved to prohibit the practice. A number of firms that had offered flash trading to clients have exited the business. The SEC ban requires a second vote by commissioners to become final.

Because many people have been unclear about the distinction, the flash-trading controversy has triggered worries about high-frequency trading, which involves strategies that appear to be perfectly legal. In some cases, high-frequency traders test prices by issuing buy or sell orders that are withdrawn in milliseconds, giving those traders insight into investors’ willingness to trade at specific prices. High-frequency traders can also earn tiny profits, millions of times over, from “rebates” provided by exchanges to players willing to buy and sell when there is a shortage of other traders.

Winners and Losers

But if high-frequency traders are making billions, is someone else — the ordinary investor, perhaps — losing money?

Gus Sauter, chief investment officer of the Vanguard Group mutual fund company, says he doesn’t think so, noting that the stock market has had middle men for hundreds of years. To assure liquidity — the constant availability of shares, buyers and sellers — these “market makers” complete sales by buying and selling in their own accounts if they cannot immediately match buyers and sellers. Market makers earn a profit on the difference between the bid prices buyers are willing to pay for a stock and the askprices sellers are willing to accept. High-frequency traders have moved this process into the 21st century, Sauter says, arguing that profits they earn are “likely less than was taken out of the system” previously by traditional market makers. “If they were doing what they do without computers, we would call them market makers,” he says.

According to Blume, ordinary individual investors with long-term buy-and-hold strategies need not fear that high-frequency traders’ profits are coming out of their pockets, because those billions represent tiny sums spread over millions and millions of trades.

Indeed, Sauter says that Vanguard’s small investors have benefitted from a significant reduction in trading costs due to high-frequency trading. Among these costs, which come on top of the “expense ratios” that fund investors are familiar with, is the bid-ask spread. A wide spread means the fund must pay significantly more to acquire a stock than it could sell it for at the same moment. High-frequency trading has reduced this cost by narrowing spreads, he states. Generally, wide spreads are seen as a kind of inefficiency, with buyers and sellers having difficulty agreeing on a price that accurately reflects what is known about a stock. Narrow spreads mean the market is working better.

Another transaction cost arises from the fact that a fund company’s huge trades can drive prices up or down by tipping the balance of supply and demand. High-frequency trading has helped reduce this “market-impact” cost by making it easier to break big trades into many little ones while still conducting them very quickly, Sauter says.

Trading costs from spreads and market impact have been cut in half over the past decade, he says, from 0.5% of the trade amount for big company stocks to 0.25%. For small stocks, trading costs have dropped from 1% to 0.5%. “High-frequency trading teases out hidden liquidity. There may be something out there that’s difficult to find. The high-frequency people do find it one way or another, and they turn around and offer it back into the marketplace.”

Sauter and representatives of three other fund firms recently met with SEC officials to discuss high-frequency trading, with three of the four fund officials arguing that it has benefitted the industry. Still, there is enough disagreement among fund companies, with some worried about front running and market manipulation, that their trade group, the Investment Company Institute, has taken a middle-of-the-road position, merely urging the SEC to study the matter thoroughly before issuing any new regulations.

Mutual Fund Investors vs. Individuals

While high-frequency trading may benefit some market participants, some experts wonder whether there are unseen hazards and fairness issues. “There is an equity issue,” Blume says. “For every trade, there is a gainer and a loser, and the presumption is that high-frequency traders are the more adept traders at the expense of the less adept traders. Now, is that good or bad? I don’t know.” If enormous profits can be made on tiny price variations, unscrupulous players could profit in small, hard-to-detect manipulation, like the kind caused by floating rumors, he notes, adding, however, that there has been no evidence this is happening. “Presumably, the SEC has the wherewithal to police that type of action. However, recent experience has shown the SEC is not as adept as one might hope.”

The SEC, Blume adds, must walk a fine line in protecting small investors. Those who are active traders could conceivably be hurt by high-frequency trading because they cannot compete with big firms’ faster computers. At the same time, high-frequency trading may benefit small investors who use mutual funds. “In my mind, the mutual fund investor should be protected at the expense of individuals who are trading on their own accounts.”

Benefits to liquidity are often cited when Wall Street comes up with a new product or strategy. Greater liquidity is a mom-and-apple pie principal that nearly all economists and market experts support in general. In theory, the markets work best when pricing reflects knowledge and insight rather than difficulty finding buyers and sellers. Hence, anything that makes it easier to find buyers and sellers makes the market more efficient. “In the ideal liquid market, trading causes prices to move just to where they want to be in terms of fundamentals,” Stambaugh says, noting that more trading in a specific security makes it more likely its price will accurately reflect factors like current and expected earnings.

But Allen notes that high-frequency trading may not be making as large a contribution to liquidity as the big trading volume numbers suggest. If many trades involve simultaneous buy and sell orders by the same trader, those are not really producing offers that other players can act on, he points out. Also, it’s not safe to assume that every new product or strategy devised by Wall Street is beneficial. “Any increase in [trading] volume is always associated in the minds of some with increased liquidity,” Blume says. “But if the trading actually destabilizes the market…then, of course, that’s not [good].”

High-frequency trading has not been studied enough to determine whether it could destabilize the markets, he adds, suggesting that regulators could temporarily ban such trading on a sample of 25 to 30 stocks, then after a few months compare their price and trading patterns with those of stocks not subject to the ban.

Over the years, according to Allen, academic research has shown that some moves to expand liquidity have opened the door to damaging types of speculation. “This kind of fast trading can give rise to frenzies,” notes Goldstein. If many traders use automated strategies that key off the same factors, such as price dips in specific stocks, the programs may all jump on the bandwagon at the same time. “This only destabilizes the market — if people start following each other, coordinating expectations. I see others selling, so I start selling myself.” For the moment, he says, it is not clear whether high-frequency trading has the potential to create this kind of crisis. “I think, at the end of the day, we don’t have the full answer.”

High-frequency trading, Allen concludes, is a practice that begs more scrutiny, like that being conducted by the SEC. “They need to try to do a study and to check exactly where these profits are coming from. Are these from manipulation? Or are they from improvements in the way the markets function?”